The eurozone’s gradual recovery continues, with share prices well up and peripheral countries’ bond yields at four-year lows. Greece is even planning to issue debt, despite a debt-to-GDP ratio exceeding 175 per cent. Yet the monetary union faces the creeping danger – the risk that allowing inflation to run so far below 2 per cent for so long could eventually push it into outright deflation.
Energy, euro appreciation, VAT effects and, more recently, food prices explain much of the inflationary decline, along with relative price adjustments in peripheral economies such as Spain that could even be described as a “good deflation”.
A low-inflation outlook will continue to encourage cash piling, delay investment decisions and cut potential growth
But the weakness of demand growth and the extent of spare capacity have also played a role, so we take little comfort from eurozone inflation being only just below US levels. The two economies are on very different recovery paths with vastly different amounts of spare capacity – particularly in the labour market.
The European Central Bank (ECB) accepts that inflation will stay very low in 2014-15 – remaining below 2 per cent even in 2016 – and has committed to an extended period of low interest rates.
But the longer inflation stays so low, the greater the risk it feeds into inflation expectations. A low-inflation outlook will continue to encourage cash piling, delay investment decisions and cut potential growth – not only because of a shrinking capital stock but because savings will increasingly be channelled into financing high government debt rather than productive investment.
We assume the ECB will take action to try to prevent the eurozone succumbing to a Japanese-style vicious cycle of low growth, further disinflation, rising debt and, eventually, falling prices. A negative deposit rate could be the next move, but we also expect some form of quantitative easing – though not before late 2014. The central bank is keen to revive the securitisation market and may dabble with purchases of private-sector assets before purchasing government bonds, but the programme would need to be big to affect the exchange rate.
And there are risks: asset-price inflation has implications for both financial stability and income inequality. Despite higher equity markets and low bond yields, the economic reality is little changed for the record numbers of unemployed youth.
Asset-price inflation is also likely to have policy implications in Europe, starting with the UK. The British housing market has rebounded strongly and unemployment has fallen, but real wages remain squeezed as nominal wage growth is rising only slowly. Tightening monetary policy in response to the housing market would squeeze incomes further, denting confidence and losing economic momentum.
The Bank of England has been clear that macroprudential measures will be the first line of defence against excess in specific markets. That could mean tougher bank capital ratios.
A slight upward revision to our forecasts for Spanish and German growth in 2015 means we now expect the eurozone to grow by 1.1 per cent compared with 0.9 per cent in 2014. But we have lowered our forecasts for eurozone inflation to 0.8 per cent this year and 1 per cent in 2015.
This research was first published on 7 April 2014.