Is the euro zone better off than it was a year ago? By most measures, the answer is yes. The region started growing again in the second quarter after 18 straight months of recession. Individual countries are whittling down their budget deficits. And a year after European Central Bank President Mario Draghi pledged to do “whatever it takes” to preserve the euro, the sovereign debt roller coaster ride that sent Spanish and Italian yields soaring in 2011 and 2012 is over. And yet, a new set of alarm bells are ringing in Europe – this time over deflation. Ironically, the very same forces that are driving the recovery are also exerting downward pressure on consumer prices. In fact, if the European Central Bank’s recent actions and comments are any gauge, policymakers are increasingly concerned the euro zone could go the way of Japan, which has struggled with deflation for the last 20 years. If the inflation outlook deteriorates further, we may see policymakers who have been focused on belt-tightening shift their efforts to stimulating demand.
The most recent inflation data out of Europe has snapped the picture into focus rather sharply. Consumer prices in the 17-nation currency bloc rose 0.9 percent in November, up only a smidgen from the 0.7 percent October level. Both numbers are a far cry from either the 2.5 percent rate posted in October 2012 or the central bank’s 2 percent target rate. Greece, Ireland and Cyprus are the only countries that reported year-over-year deflation in October, but Spain and Portugal teetered on the brink the same month, with consumer prices remaining flat. Overall euro zone inflation is likely to stay below 1 percent through the spring, and probably won’t edge much higher than 1 percent in all of 2014, Credit Suisse Senior European Economist Christel Aranda-Hassel writes in a recent note entitled “The ECB’s Arsenal.” Though Credit Suisse does not expect the European economy to contract again next year, “it would not take much” of a slowdown to tip the euro zone into outright deflation, she says.
The potential harm from falling prices is of particular concern in the heavily indebted peripheral countries. For one, higher inflation can be helpful in lightening the burden of outstanding loans. Furthermore, if consumers and businesses expect costs to continue decreasing, they might delay purchases, thus setting off a cycle in which reduced demand hurts corporate profits, leading to stagnant wage growth and – coming full circle – even weaker demand.
The deflationary cycle that Europe is a hiccup away from entering began as part of a deleveraging process that was absolutely necessary to restore investor confidence in places like Ireland and Portugal, which required bailouts from the so-called troika – the International Monetary Fund, European Central Bank and European Commission. During the crisis, peripheral countries slashed government spending and increased taxes, while financial institutions sharply reduced lending to businesses and individuals. When demand fell as a result, import levels dropped, too. At the same time, widespread unemployment in the peripheral countries drove labor costs down, making exports more competitive. High unemployment and falling wages may not be a cause for celebration, but they do help explain why countries like Spain, Italy and Ireland have moved from current account deficits to surpluses over the past year.
The real problem is that falling consumption in Europe’s smaller economies hasn’t been offset by rising domestic demand – which would tend to produce inflation – in core European economies such as Germany. What’s more, the risk of currency appreciation threatens to erase whatever trade advantages the peripheral economies have built up to date. Though Credit Suisse expects the Federal Reserve to begin tapering its $85 billion monthly asset purchases in the next three months, both the Fed and the Bank of Japan will continue large-scale asset purchase programs in some form well into next year. In fact, Credit Suisse’s Japan economists expect the BOJ to increase purchases of government bonds and equities this spring. With foreign central banks maintaining loose monetary policy and a large current account surplus in the euro zone as a whole, Credit Suisse’s foreign exchange strategists believe the euro could strengthen significantly next year.
In this environment, boosting demand in the euro zone itself is critical to averting deflation. The European Central Bank made a particularly strong statement that it intended to do just that with its surprise 25-basis-point rate cut early last month. The bank was concerned enough about defending its 2 percent inflation target that it sought to stimulate growth well before most economists expected an intervention. Though the cut “can hardly be described as a game-changer, the tone in which it was undertaken was significant,” Credit Suisse Head of European Economics Neville Hill wrote in a recent note called “Fighting Europe’s Deflationary Tendency.”
In remarks following the rate cut, Draghi and other members of the central bank’s executive board were quite explicit about how the central bank might further stimulate growth and, in turn, prevent deflation. One possibility is to cut rates further, which would introduce a negative deposit rate – in effect, charging banks to hold their excess cash overnight at the ECB. That, in theory, would encourage financial institutions in countries such as Germany – which holds more cash than any other euro-zone nation at the central bank – to either invest in assets such as peripheral countries’ sovereign bonds or to lend more money to consumers and businesses.
Policymakers could also proceed with programs that would increase liquidity to financial institutions. One of the most-discussed measures is another round of cheap multi-year loans to euro-zone banks, known as a long-term refinancing operation. The ECB has already performed two such injections, first in 2011 and again in 2012, and Aranda-Hassel says instituting another one would particularly help banks in Spain, Portugal, Italy and Greece. But she also notes that it would be problematic for the central bank to infuse more cash into European financial institutions at the same time that it is gearing up to run large-scale stress tests on them early next year.
Finally, Aranda-Hassel said, the European Central Bank could join the Federal Reserve and Bank of Japan in buying financial assets outright. If Europe’s central bankers went that route, she believes, they would probably want to purchase corporate debt as well as sovereign bonds. But the central bank is only likely to take that step if the inflation outlook deteriorates significantly, something Credit Suisse does not expect. Still, the fact that the central bank is publicly discussing the tools at its disposal means it “stands ready to act if inflation falls further,” says Aranda-Hassel.