Euro Deflation Scare To Stay With Us For Some Time

The big theme in the euro area has become the risk of deflation. Our forecast for inflation suggests that the deflation scare will stay with us for some time – and might very well intensify. While we do not expect deflation, we do see inflation coming even lower over the next six months to bottom in March next year at 0.5% y/y (currently at 0.7% y/y) – see ECB reaction to inflation over the next six months, 19 November. A decline in food prices and technical factors in Germany push the inflation rate even lower.

The heat will thus continue to be on the ECB to defend its inflation target of below but close to 2% inflation. What is important for the ECB is that inflation expectations are anchored around its target and do not start to drift lower. If it allows inflation to be too far away from its objective without acting, it runs the risk that inflation expectations go down.

It is the same argument the ECB used when inflation was high due to high oil prices – as was the case when the ECB hiked in 2008. The ECB knew it could not get the oil price lower by hiking but if it refrained from reacting it risked inflation expectations moving higher in which case the ECB would see a big hit to its credibility. Consequently, the ECB is now keeping a close eye on inflation expectations. For now it is still anchored at close to 2% but there is a risk it moves lower if inflation stays low for long without the ECB reacting. This would cause a similar hit to credibility, which the ECB will not allow. This is why we expect more easing from the ECB in early 2014, when we look for another 3-year LTRO to be introduced. A cut in the refi rate is also possible but the bar for implementing a negative deposit rate seems very high. This was highlighted this week by both ECB president Mario Draghi and German ECB member Joerg Asmussen, who said he would be very, very cautious.

In the past weeks we have addressed the issue of whether the decline in inflation is dangerous. In our view it is not, because it is to a wide extent driven by a pass through of the past two to three years’ decline in commodity prices and it has given a lift to real wage growth from -1% to 0.75% in the euro area, which is clearly supporting growth – see also Deflation is not always a bad thing, 8 November. Inflation is like a tax on income and the decline in inflation can be compared to a decent tax cut for euro consumers over the past year.

This week we got another piece of evidence that lower inflation is not contradicting stronger growth– on the contrary. The German IFO index took another jump higher in November to the highest level in more than two years. German PMI data showed a similar picture. This is happening alongside a drop in inflation from close to 3% in mid- 2011 to currently 1.2%.

To Read the Entire Report Please Click on the pdf File Below.