Friday 26 December 2014

With our high level of household debt, we'll suffer if deflation spreads across eurozone

Published 06/05/2014 | 02:30

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Thinkstock Images

Ireland's fate is bound up with Europe's. The European Commission's spring forecasts for the eurozone are not looking good, and that is bad news for us. Only Europe's authorities can claim a recovery is under way with low inflation expectations and higher than expected unemployment, with growth expected to be barely above 1pc. Averages don't mean much in an 18-country monetary union, so looking at individual countries, we can see evidence the eurozone's member states may be experiencing elements of a deflationary spiral. In Germany, Estonia, Hungary, Greece, Cyprus and Ireland, consumer prices fell on a year-over-year basis in 2013.

Yet the European Commission's argument that deflation is not a real risk is that it is unlikely to take place in the larger core economies. From page 25 of the Spring Forecast: "The risk of outright deflation, defined as a generalised and self-reinforcing fall in prices in the euro area as a whole, remains low. For such a scenario to materialise, inflation would have to drop sharply to almost zero in the core countries of the euro area. Shocks that would trigger such a drop in core inflation are very unlikely."

Of course the commission doesn't outline exactly what those shocks might be; and worse, the argument from the commission is oddly circular. We won't see deflation because we don't see very low inflation figures in the bigger countries.

And yet, when we look at the figures, we do see prices falling – especially for producers and intermediaries.

The argument for the core versus the periphery is that the periphery is supposed to see price decreases as a consequence of regaining its competitiveness. So we shouldn't be too worried in seeing changes there, at least in the short term. This argument makes sense to me.

That said, looking at the 18 countries of the eurozone, when we dig into producer price indices, we see they have been falling for quite some time. Now, some of that may be falling energy costs, so when you strip out the effects of falling energy costs, you get a rather strange picture: the producer prices for intermediate goods, industrial activities, and manufacturing, are falling relative to the same period from last year, since August 2013.

Again, the eurozone is a massive economic bloc, so these averages aren't that informative. Let's contrast Ireland, Germany, and France, in terms of the producer price index for manufacturing. What do we see?

Every single country's price levels have been dropping relative to the same period last year, since August 2013. The data give the lie to the Commission's forecasts, in a sense, because they show sustained price falls exactly where we would expect to see them in a deflationary environment: in the prices facing producers, rather than consumers.

This will help firms repair their balance sheets in the short term as firms' margins improve but eventually these lower prices will find their way to consumers, and the consumer inflation forecasts for the commission may turn out to be far too optimistic.

Why does this matter for Ireland? In a country with very, very high household and corporate debt relative to national output, even low inflation poses large risks for us – and a deflation in our major trading partners would be a disaster.

Ireland is projected to grow quite a bit over the period from 2014 to 2016, but only under the assumption that deflation isn't going to happen.

Now we have to be careful when talking about deflationary risks, because of the expectational component of the deflation cycle.

It is your expectations about falling prices which cause prices to fall even further. So the European Commission can't really come out and feed those expectations, or the cycle will become much more likely. Equally important, we need to constantly refer to real world data, and not hearsay or conjecture when talking about deflation – precisely because of this expectational component.

The key for Ireland, and Ireland's policymakers, particularly in the Department of Finance, is to monitor changes in the components of these price indices very carefully – not just in Ireland, but with respect to our major trading partners.

The commission is absolutely right when it says that deflation won't be a major feature of the eurozone until it appears within the core economies of France and Germany.

One worrying piece of data I've shown here is that prices are already falling there, too.

And where we go next, once the European Central Bank institutes large-scale asset buying towards the end of the year, is anyone's guess. But one thing is clear: the Commission's forecast on the likely risks of deflation looks too optimistic by far.

Irish Independent

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