Macro Weekly – Why deflation fears are overdone

by: Han de Jong

Big Picture - 24 October 2014 - Why deflation fears are overdone.pdf ()

The dreaded D-word is on the rise, and spectacularly so. Inflation is below target in most countries and many fear that outright deflation will be next. It is seen as a grim prospect. I would like to make a number of observations on the deflation threat and conclude that while the risk must not be ignored, there is a tendency to exaggerate the dangers and the consequences. Do not panic, is my advice.

Pop star popularity and horror movies

Inflation is below target in many countries. Some are experiencing negative inflation. So it is no surprise that people worry about deflation. It is equally understandable that many associate deflation with a horror scenario. In the 1930s deflation gripped many economies during the Great Depression and Japan has been struggling with deflation since the mid 1990s. That said, it seems to me that commentators are losing all sense of perspective and the topic of deflation is enjoying something similar to pop star popularity in economic discussions. This week, The Economist opines that ‘sooner rather than later – the euro will collapse’ and it carries a special report on deflation with a very bearish tone. I think all of this is overdone and the only good thing is that when the consensus ventures up a blind alley, this will create investment opportunities by the time the consensus turns.

Good and bad

My first point is that it is important to distinguish between good and bad deflation. Good deflation is a drop of the general price level caused by technological progress and productivity gains or by a drop of prices of inputs used in the production process, such as oil. If prices drop while my income stays the same, that is good for me, right? Bad deflation is caused by a lack of demand causing producers to cut prices and, in turn, wages. The cut in wages may be rational for an individual company, but if all companies do so, this will reduce overall demand further. A negative, vicious spiral is born.

Making the distinction between good and bad deflation is easier in theory than in practice. Headline inflation in the eurozone is only 0.3% and has fallen steadily in many months. Core inflation, on the other hand, has been moving sideways for a year or so in a range of 0.7-1.0%. That is too low for comfort, but it is not deflation. The recent further decline in headline inflation has been caused by oil prices. That is good, not bad. Pessimists argue that even the drop in oil prices is bad as it is seen as a signal of global economic weakness. I do not buy that argument. The sharp drop in oil prices in 2008 was one of the factors that set the basis for the eventual economic recovery. In addition, oil production is on the rise. There simply is a glut of oil, which is not only due to weak demand.



Inflation expectations

The ECB has long maintained that inflation expectations have been anchored around 2%, but on some measures they have now fallen and if such expectations influence behaviour, this could become a self-fulfilling prophecy. Graph 1 shows that inflation expectations in the eurozone have become dislodged and also shows that they move in tandem in the eurozone and in the US, though expectations in the US are consistently higher.

The question here is what has caused the recent drop in inflation expectations. Graph 2 sheds some light on the issue. The recent decline in inflation expectations coincides with the drop in oil prices. And that makes sense. This is not to say that we have nothing to worry about. But it means that the recent drop in inflation expectations (in the eurozone as well as the US) is not a sign of increasing fear for bad deflation, but simply a reflection of falling oil prices.



What pushed Japan into deflation and how does Europe currently differ?

Japan fell into (mild, but sustained) deflation as a result of a couple of factors. First was the bursting of asset bubbles. It must be borne in mind that the asset bubbles in Japan were colossal. The Nikkei fell from almost 39,000 to 15,000 and then stayed there. House and land prices fell consistently over a 20-year period. And the value of the yen trebled over a 10 year period, rising from 250 yen per dollar in 1985 to 85 in 1995. Europe has not experienced anything like that. In addition, Japan’s demographics became unfavourable in the period before and during deflation. European demographics are currently also unfavourable, I must admit. Another point is that Japanese policymakers responded too late and were generally very hesitant. This is true for monetary policy, fiscal policy and tackling the problems in the banking system. The response by European policymakers could have been more aggressive, but it was certainly much more assertive. Last, but not least, Japan experienced massive disinflationary pressure from the rise of China as a fierce competitor, producing from an extremely low cost base. This is much less true for the eurozone under current circumstances.

The final push

It is interesting to look at what pushed Japan over the edge into deflation. Graph 3 shows inflation and unemployment. Unemployment is measured on a reverse scale, so a rise in the yellow line indicates a drop in unemployment. While the relationship is by no means one-on-one, it is clear that there is a strong correlation. And I am convinced that the causal relationship runs from unemployment to inflation. Unemployment in Japan started rising in 1992 and then rose persistently for a period of 10 (!!) years, apart from two brief spells of stabilisation. The lesson is that deflation happens during periods of persistenly rising unemployment.



The eurozone shows a similar relationship between the labour market and (core) inflation. The positive message I take from graph 4 is that unemployment in the eurozone is currently falling, and that should limit the chances of bad deflation. Admittedly, unemployment is high and the negotiating power of workers is therefore low. Wages have been cut in peripheral countries in order to restore competitiveness, but falling wages are not the norm for the eurozone as a whole. In fact, wage increases appear to be edging higher. The recent stabilisation of core inflation seems to be a predictable response to the gentle decline in unemployment.



If the labour market holds the key, what does the future look like?

Whether or not the economy is likely to experience persistent, bad deflation largely seems to depend on the labour market. A sustained rise in unemployment leads to a drop in wages, which can eventually translate into bad deflation. The European labour market has turned, for now. This should limit the deflation risks. What are the prospects? The fortunes of the labour market obviously depend on the performance of the overall economy. Growth is good, contraction is bad. We are currently in a phase of modest growth, although many eurozone economic indicators have disappointed in recent months. As I have argued here repeatedly, I think recent disappointments do not indicate a new trend. They are temporary. Growth is set to continue and to accelerate somewhat into next year. This week’s PMI’s in Germany were supportive of my argument. Business confidence had weakened as has industrial production. But October’s PMI for Germany shows a recovery of business confidence in October. My main argument for optimism on the eurozone outlook is that the eurozone is starting to benefit from a couple of tail winds. The drop in oil prices makes a big difference. The weaker euro is also helpful. Interest rates have fallen massively along the curve in the eurozone and the most in the periphery. In addition, the worst of austerity is behind us and the credit channel is gradually healing, as witnessed by the last two issues of the ECB’s quarterly bank lending survey.

What about outright deflation in the eurozone periphery?

As we worry about deflation and its effects for the eurozone as a whole, we often forget that several eurozone countries have experienced deflation for a while. How has their economic performance been affected? Portugal has been in mild deflation for more or less a year. During this period GDP growth has improved from -3.8% yoy in Q1 2013 to +0.9% in Q2 2014. Consumer and business confidence have improved strongly. Greece has experienced somewhat deeper deflation than Portugal and for a longer period, almost two years now. While one cannot be very cheerful about the Greek economic performance, GDP growth has improved over this period from -7.7% yoy in Q3 2012 to -0.3 in Q2 2014. During the same period, the European Commission’s index of Economic Sentiment in Greece has risen sharply. Spain has recently also fallen into mild deflation, but its economy is clearly recovering. GDP growth has moved from -2.0% yoy in Q4 2012 to +1.2% recently. The conclusion I draw is that deflation in these countries has not led to bad performance, but has actually coincided with improving economic performance. The fall in prices in these countries partly reflected sharp falls in unit labour costs. This has not turned into a vicious circle of falling demand, falling prices, falling wages etc., as improved competitiveness and the resulting contribution from net trade have been the engine of growth. This growth will be sufficient to prevent the vicious circle from setting in on a sustained basis. Of course, sceptics would say: ‘just wait….’ What can I say? There will always be sceptics and pessimists. That is a good thing as it creates opportunities for realists.