Decline Of Euroarea Inflation Raises Fears Of Weak Economic Preformance

The sharp decline in euroarea inflation has led to a return of the deflation ghost and fears that the euroarea economy could end in a deflation trap like Japan and a prolonged period of very weak economic performance.

However, one has to be a bit careful.First of all, inflation is at 0.7% in the euroarea , which is still a bit away from negative territory. Secondly, whether deflation is dangerous depends on what is driving it. Deflation generally stems from two sources.

1. Demand-driven deflation. Declining activity pushes up the unemployment rate and leads to declining wage growth – or sometimes very low levels of wage growth. Weak pricing power means companies have to lower prices to attract demand. This has been the pre-dominant source of deflation in Japan over the past 20 years.

2. Supply-driven deflation. Higher productivity growth (as in the 1990s) and/or lower input costs can push inflation lower. If the downward pressure is strong enough, this can lead to deflation.

There is a big difference between these two kinds of deflation and their economic effects. When wages are in a downward spiral pushing consumer prices even lower, it can turn into a vicious circle. Lower wages diminish the ability to service debt, which adds to downward pressure on house prices, which in turn reduces wealth. Lower wealth increases the leverage ratio for consumers if the household debt level stays broadly the same, which then leads to more saving by consumers to the detriment of economic recovery. This is quite close to what Japan has experienced. A high degree of wage flexibility (i.e. bonus is a large part of the wage pay) reinforces the tendency for wages to go lower.

The second kind of deflation, though, is a positive kind. When commodity prices fall due to a positive supply shock, it frees up consumers’ purchasing power since they have to spend less to fill up the car or heat the house. Also, if higher productivity growth – as we saw in the 1990s - means it is cheaper to produce a computer or DVD-player, it either means we can buy more DVD-players and TVs or we can use more money on other things, which is positive for the economy.

So, where are the deflationary pressures coming from today? It looks like both factors are at play currently but the recent push lower in inflation most likely stemsmore from falling commodity prices than from renewed downward pressure on wagegrowth. In both the US and the euroarea nominal wages have been rising around 1.5%for some time - due to high unemployment.

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