Eurozone at risk of deflation shock as ECB mulls its options
Traders still expect policy action next week, but not all disinflation is seen as a problem for the single currency
Yesterday’s upward revision to January’s Eurozone inflation reading did little to calm the nerves of those worried about a possible slip into Japanese-style deflation. The harmonised index of consumer prices (HICP) was revised up from 0.7 to a 0.8 per cent year-on-year rise in January, but the downside risks were underscored by a 1.1 per cent drop in prices from December. The euro wobbled slightly against the pound, with sterling-euro rising well above €1.21 yesterday, before paring back again in the afternoon.
To some, there are signs of a worrying disconnect between the market’s fears of deflation and the reluctance of European Central Bank (ECB) governor Mario Draghi to sanction more radical policy. Italy, the region’s third largest economy, yesterday posted a 2.1 per cent month-on-month drop in consumer prices for January, while Greece and Cyprus remain stuck in deflation. Only Estonia, Latvia and Slovakia saw a month-on-month rise.
Alan Higgins of Coutts summed up the mood of many analysts yesterday – “low inflation has been a persistent problem in the euro area, and with the ECB appearing complacent, the risk of deflation is mounting.” With an ECB meeting scheduled for next Thursday, traders will closely watch this week’s releases (M3 money supply figures, the Eurozone unemployment rate, and flash February inflation data) for signs as to whether the situation could be judged dangerous enough to warrant further monetary easing.
THE CASE FOR OPTIMISM
The charge of complacency may be a little harsh, and some find cause for optimism in the breakdown of the headline figures. “One way of thinking about it is to split the possible causes of disinflation into internal and external ones,” says Christian Schulz of Berenberg Bank. “When you strip out more volatile external factors like energy prices, there are good reasons to think that at least parts of the Eurozone will see rising inflation in the near term.”
Energy prices were flat year-on-year in December, but fell by 1.2 per cent in January compared to a year earlier, cutting the headline inflation figure by around 0.13 percentage points. But the return of growth in the Eurozone, which mildly accelerated from 0.1 per cent to 0.3 per cent in the final quarter of 2013, is likely to see upward internal pressure on these prices, says Schulz. Moreover, as Michael Hewson of CMC Markets argues, some recent disinflation is a natural result of reforms aimed at improving productivity in the periphery. Wage cuts, for example, can have an near-term negative effect on prices, but should help to boost growth and eventually inflation in the long run.
But this highlights a potential problem. Italy and France, as Hewson points out, have barely started some of the necessary labour market reforms to boost productivity. And with new Italian Prime Minister Matteo Renzi promising action, at least one of the Eurozone’s largest economies could see falling wages in the near future. “And monetary policy can’t really do much about this,” Hewson says.
A SUDDEN SLIP
Perhaps more worrying is the danger that a sudden external shock could materialise, de-anchoring inflation expectations and risking all-out deflation. In an analysis released yesterday, Rabobank modelled various scenarios to work out what would have to happen for the region to slip into deflation. A large fall in commodity prices (about 50 per cent spread over a year), or a 3 per cent dip in Eurozone GDP, would be enough to induce such a situation, they concluded. Another danger identified is that recent euro strength (see graph) becomes even more acute – a rise of at least 20 per cent could lead to deflation in the Eurozone, according to Rabobank.
Each of these situations may seem remote, but the note’s author points out that an external shock, like a sudden slowdown in China, would likely hit Eurozone GDP, commodity prices, and the exchange rate all at once. This combination of smaller shocks could equally induce a bout of deflation.
DRAGHI’S OPTIONS
Will the ECB’s governing council decide to act in its next meeting to meet these dangers? “Some are anticipating that the ECB will cut its main rate to a record low of 0.10 per cent, and the interest rate on the deposit facility to negative territory,” says Dean Popplewell of OANDA. Anything less than this would likely see short-term euro strength, according to FxPro’s Angus Campbell, and a related hit to riskier assets such as European equities.
Another option is an extension of the Long-Term Refinancing Operations (LTRO) – where the ECB grants cheap loans to banks to boost cash flow in the market. Ashraf Laidi of City Index says that “the next policy measure could likely emerge from an LTRO option with a twist, which means requiring banks to spend proceeds in the economy, rather than just buying bonds.” Such a move would likely be euro-positive, he says, as it was when the LTROs were introduced in December 2011.
But sharp regional imbalances in the Eurozone may well turn the ECB against radical moves to ease policy – whether the introduction of QE or a rate cut. Laidi points out that Germany’s Dax equity index is barely 1 per cent away from all-time highs, while Spain’s Ibex is trading 73 per cent higher than in August 2012. It is difficult to imagine the Germans liking a rate cut, especially while fears of a housing bubble abound. Overall, a lot will depend on the ECB’s new forecast for inflation in 2016, says Saxo Capital Markets’s Nick Beecroft. “If this shows a medium-term uptick in inflation, the ECB will probably try and see through the current dip.”