Harvinder Sian
RBS
Low inflation is now a structural problem and a key focus for Europe next year. We are looking at a near 1% steady state level now that the periphery is starting to put reforms in place.
The euro area is fundamentally a competitive disinflation machine.
It has a debt overhang problem that remains unsolved. The rise in private debt is merely slowing in a number of countries and is only falling meaningfully in Germany and Spain.
Without tax, inflation has not been above 2% for several years. Our models point to a sub-1% trend by the end of 2014 and it is difficult to see where the upward inflation impulse is going to come from next given that German wages are not rising and macroprudential policy may well be used to mitigate the country’s boom risks. For example, a typical sign of an overheating inflationary boom is a rise in credit and this is still falling in Germany.
Low inflation is good. You can ‘buy more stuff’ as ECB President Mario Draghi is keen to tell the market. The danger, however, is that inflation expectations fall and lock markets into a liquidity trap.
The ECB will be very sensitive to that. It would be one of the main triggers to bring the central bank into play. It can cut rates or add more liquidity, but it needs to increase money supply and get the banks working again to really fix the deflation problem.
Its asset quality review and stress test of eurozone banks will help, but credit easing via bank loan purchases is the game changer that would get the euro area moving forward on a more even keel. Unfortunately, the ECB is very far from any such move.
The future of the eurozone depends on greater homogeneity; the continent needs relatively close growth performance. It needs France and Italy to introduce vital reforms and enter Europe’s competitive devaluation war. Both countries must liberalise the labour markets and the non-traded sector.
France has made some movement towards wage moderation, but its adjustment needs are not yet critical. Unfortunately, the same cannot be said of Italy, which is rapidly losing market share and has a much higher risk associated with unemployment, as well as an unstable political backdrop.
These changes are vital for Europe’s survival because, despite some steps in the right direction, the financial crisis is far from over in the region.
Of course, some progress has been made. We now have a lender of last resort in the ECB – a very significant move that has bought time for more homework to be done to solve problems.
This homework is happening to some extent within the Banking Union and we are seeing some economic reforms coming through in some regions.
What is really needed now is a political agenda to change the economic landscape. Hitherto that has only happened under market duress. It would need to incentivise Italy and France to carry out the necessary reforms for a start. It is unclear whether that shift will happen in enough size so it is far from plain sailing from here.
(Harvinder Sian is co-head of European Economics, Rates and CEEMA Research at RBS)