James Saft, Reuters Columnist
Europe faces a threat of deflation, which it seems unlikely to be willing to fight.
Core inflation in the eurozone fell sharply in October to just 0.8% a year, the lowest since early 2010 and a level which sets the red deflation light flashing.
Deflation, or even low inflation, is particularly bad news for Europe, whose particular burden is too much debt. Inflation eats away at the real value of debt, thus making it easier to bear. Deflation does the opposite.
This raises pressure on the European Central Bank, which has a monetary policy meeting next week, to do something radical, though they have but limited options when it comes to the what and the how.
Buried in the inflation figures was one number which shed light on the eurozone’s plight: the prices of services fell 0.2% in October, and are down 1.2% from a year ago. Services, of course, are what Europeans perform largely for one another, and since the number of people needing work so far outpaces the available opportunities, a crushing deflation in what they can charge ensues.
And because the eurozone ties all member states to the same exchange rate, those places like Greece and Spain with the worst unemployment are forced to compete internationally to sell traded goods and services with the likes of Germany, making deflation the natural outcome.
Eurozone unemployment rose to a record high of 12.2% in September, according to data released on Thursday, with an all-time record of 24.1% of those under 25 years old jobless. Unsurprisingly, French consumer spending and German retail sales are both falling outright.
“So the question of the day can be couched into what can the ECB do to make policy more accommodative,” Bob Savage of Track Research wrote in a note to clients.
“Some banks are now calling for another 25bp easing in the refi rate. Others stick to the 9M LTRO idea. Some are thinking of more forward guidance linked to CPI. All equal a lower euro.”
Though the eurozone common currency fell nearly 1% against the dollar on Thursday, that still leaves it some 6% higher over a year, a burden on exporters.
No costless options
The idea of a new or additional LTRO – long-term loans offered to banks to drive market interest rates lower – is baked into most economists’ forecasts. More than €1trn of LTRO loans were made in 2011 and 2012 and the first repayments are due early next year.
As for reducing interest rates, it will be tricky. The main refi rate is at 0.50%, but the deposit rate is already zero. If the deposit rate went negative, implying a charge on banks for funds held at the central bank, banks might be more likely to make loans but would face difficulties in their own operations. It would also cause problems in bond and other funding markets.
Forward guidance, a fancy central banker term for making a promise about what you will do in the future, is seen as a sort of magic bullet for banks facing the zero bound of interest rates. Commit to keep rates low for longer and you can influence markets, the theory goes, to price credit more cheaply for longer periods. In its most recent ECB Monthly Report, the bank said again that rates will remain at the current low or lower levels for an extended period in order to support a gradual recovery in euro zone economic activity.
The other question, of course, is what reaction other central banks and governments have to a falling euro. The US on Wednesday took aim at Germany for what it said was creating a “deflationary bias” for the euro area by maintaining a large current account surplus. In the absence of some sudden uptick in German demand for Greek, Italian and Spanish goods, a lower euro will only reinforce that, and might invite US ire.
As well, the Federal Reserve and Bank of Japan are both fighting their own wars against falling inflation in the US and outright deflation in Japan. While a small move in the euro might be tolerated, a larger one would raise tensions.
The real problem, as ever in the eurozone, is that the solution will involve German authorities tolerating inflation at home, specifically inflation in German wages. That would drive German consumption and narrow the competitiveness gap within the eurozone. To put it bluntly, this is unlikely.
That leaves the eurozone dependent on global growth, which may or may not deliver the inflation needed to make its debts bearable.
That growth may or may not arrive, but what is certain is a lot of suffering in peripheral Europe while we wait and see.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)