Macro Weekly - Why deflation fears are overdone

Macro Weekly
Why deflation fears are overdone
Group Economics
Han de Jong
Chief Economist
24 October 2014
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
economic recovery. In addition, oil production is on the rise.
Inflation is below target in many countries. Some are
There simply is a glut of oil, which is not only due to weak
experiencing negative inflation. So it is no surprise that people
demand.
worry about deflation. It is equally understandable that many
associate deflation with a horror scenario. In the 1930s
deflation
gripped
many
economies
during
the
Inflation expectations (5yr/5yr)
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
2.8
2.6
enjoying something similar to pop star popularity in economic
2.4
discussions. This week, The Economist opines that 'sooner
2.2
rather than later - the euro will collapse' and it carries a special
2.0
report on deflation with a very bearish tone. I think all of this is
1.8
overdone and the only good thing is that when the consensus
ventures up a blind alley, this will create investment
1.6
Jan 14
Mar 14
opportunities by the time the consensus turns.
Good and bad
May 14
Eurozone
Jul 14
Sep 14
US
Source: Bloomberg
My first point is that it is important to distinguish between good
and bad deflation. Good deflation is a drop of the general price
Inflation expectations
level caused by technological progress and productivity gains
The ECB has long maintained that inflation expectations have
or by a drop of prices of inputs used in the production process,
been anchored around 2%, but on some measures they have
such as oil. If prices drop while my income stays the same,
now fallen and if such expectations influence behaviour, this
that is good for me, right? Bad deflation is caused by a lack of
could become a self-fulfilling prophecy. Graph 1 shows that
demand causing producers to cut prices and, in turn, wages.
inflation expectations in the eurozone have become dislodged
The cut in wages may be rational for an individual company,
and also shows that they move in tandem in the eurozone and
but if all companies do so, this will reduce overall demand
in the US, though expectations in the US are consistently
further. A negative, vicious spiral is born.
higher.
Making the distinction between good and bad deflation is
The question here is what has caused the recent drop in
easier in theory than in practice. Headline inflation in the
inflation expectations. Graph 2 sheds some light on the issue.
eurozone is only 0.3% and has fallen steadily in many months.
The recent decline in inflation expectations coincides with the
Core inflation, on the other hand, has been moving sideways
drop in oil prices. And that makes sense. This is not to say that
for a year or so in a range of 0.7-1.0%. That is too low for
we have nothing to worry about. But it means that the recent
comfort, but it is not deflation. The recent further decline in
drop in inflation expectations (in the eurozone as well as the
headline inflation has been caused by oil prices. That is good,
US) is not a sign of increasing fear for bad deflation, but simply
not bad. Pessimists argue that even the drop in oil prices is
a reflection of falling oil prices.
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
2
Macro Weekly - Why deflation fears are overdone - 24 October 2014
Inflation expectations driven by oil
Inflation and unemployment in Japan (%)
Inflation % yoy
Unemployment %
130
2.8
10
0
120
2.6
8
1
2.4
6
110
2.2
100
0
90
1.8
-2
80
Jan 12
1.6
Jan 13
Brent crude (l.a.)
Jul 13
Jan 14
3
2
2.0
Jul 12
2
4
4
5
-4
6
80
Jul 14
83
86
89
92
95
98
Inflation (lhs)
Eurozone 5y5y (r.a.)
01
04
07
10
13
Unemployment (rhs)
Source: Bloomberg
Source: Bloomberg
What pushed Japan into deflation and how does Europe
The eurozone shows a similar relationship between the labour
currently differ?
market and (core) inflation. The positive message I take from
Japan fell into (mild, but sustained) deflation as a result of a
graph 4 is that unemployment in the eurozone is currently
couple of factors. First was the bursting of asset bubbles. It
falling, and that should limit the chances of bad deflation.
must be borne in mind that the asset bubbles in Japan were
Admittedly, unemployment is high and the negotiating power of
colossal. The Nikkei fell from almost 39,000 to 15,000 and then
workers is therefore low. Wages have been cut in peripheral
stayed there. House and land prices fell consistently over a 20-
countries in order to restore competitiveness, but falling wages
year period. And the value of the yen trebled over a 10 year
are not the norm for the eurozone as a whole. In fact, wage
period, rising from 250 yen per dollar in 1985 to 85 in 1995.
increases appear to be edging higher. The recent stabilisation
Europe has not experienced anything like that. In addition,
of core inflation seems to be a predictable response to the
Japan's demographics became unfavourable in the period
gentle decline in unemployment.
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
Inflation and unemployment in Eurozone (%)
Core inflation % yoy
Unemployment %
very hesitant. This is true for monetary policy, fiscal policy and
3.0
6
European policymakers could have been more aggressive, but
2.5
7
it was certainly much more assertive. Last, but not least, Japan
2.0
experienced massive disinflationary pressure from the rise of
1.5
China as a fierce competitor, producing from an extremely low
1.0
tackling the problems in the banking system. The response by
cost base. This is much less true for the eurozone under
current circumstances.
8
9
10
11
0.5
12
0.0
13
00
02
04
06
08
10
12
14
The final push
Inflation (lhs)
It is interesting to look at what pushed Japan over the edge
into deflation. Graph 3 shows inflation and unemployment.
Unemployment (rhs)
Source: Bloomberg
Unemployment is measured on a reverse scale, so a rise in
the yellow line indicates a drop in unemployment. While the
If the labour market holds the key, what does the future
relationship is by no means one-on-one, it is clear that there is
look like?
a strong correlation. And I am convinced that the causal
Whether or not the economy is likely to experience persistent,
relationship
inflation.
bad deflation largely seems to depend on the labour market. A
Unemployment in Japan started rising in 1992 and then rose
sustained rise in unemployment leads to a drop in wages,
persistently for a period of 10 (!!) years, apart from two brief
which can eventually translate into bad deflation. The
spells of stabilisation. The lesson is that deflation happens
European labour market has turned, for now. This should limit
during periods of persistenly rising unemployment.
the deflation risks. What are the prospects? The fortunes of the
runs
from
unemployment
to
labour market obviously depend on the performance of the
3
Macro Weekly - Why deflation fears are overdone - 24 October 2014
overall economy. Growth is good, contraction is bad. We are
7.7% yoy in Q3 2012 to -0.3 in Q2 2014. During the same
currently in a phase of modest growth, although many
period, the European Commission's index of Economic
eurozone economic indicators have disappointed in recent
Sentiment in Greece has risen sharply. Spain has recently also
months. As I have argued here repeatedly, I think recent
fallen into mild deflation, but its economy is clearly recovering.
disappointments do not indicate a new trend. They are
GDP growth has moved from -2.0% yoy in Q4 2012 to +1.2%
temporary. Growth is set to continue and to accelerate
recently. The conclusion I draw is that deflation in these
somewhat into next year. This week's PMI's in Germany were
countries has not led to bad performance, but has actually
supportive
had
coincided with improving economic performance. The fall in
weakened as has industrial production. But October's PMI for
of
my
argument.
Business
confidence
prices in these countries partly reflected sharp falls in unit
Germany shows a recovery of business confidence in October.
labour costs. This has not turned into a vicious circle of falling
My main argument for optimism on the eurozone outlook is
demand, falling prices, falling wages etc., as improved
that the eurozone is starting to benefit from a couple of tail
competitiveness and the resulting contribution from net trade
winds. The drop in oil prices makes a big difference. The
have been the engine of growth. This growth will be sufficient
weaker euro is also helpful. Interest rates have fallen
to prevent the vicious circle from setting in on a sustained
massively along the curve in the eurozone and the most in the
basis. Of course, sceptics would say: 'just wait....' What can I
periphery. In addition, the worst of austerity is behind us and
say? There will always be sceptics and pessimists. That is a
the credit channel is gradually healing, as witnessed by the last
good thing as it creates opportunities for realists.
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 -
4
Macro Weekly - Why deflation fears are overdone - 24 October 2014
KEY MACRO EVENTS
Day
Date
Time
Country
Monday
Monday
Monday
Monday
27/10/2014
27/10/2014
27/10/2014
27/10/2014
09:30:00
10:00:00
10:00:00
15:00:00
NL
DE
EC
US
Tuesday
Tuesday
Tuesday
Tuesday
28/10/2014
28/10/2014
28/10/2014
28/10/2014
09:30:00
13:30:00
14:00:00
15:00:00
Wednesday
Wednesday
Wednesday
Thursday
Wednesday
Wednesday
29/10/2014
29/10/2014
29/10/2014
29/10/2015
29/10/2014
29/10/2014
Thursday
Thursday
Thursday
Thursday
Thursday
Friday
Friday
Friday
Friday
Friday
Friday
Friday
Friday
Key Economic Indicators and Events
Period
Latest outcome
Consensus
Producer confidence manufacturing - index
Ifo - business climate - index
M3 growth - % yoy
Pending home sales - % mom
Oct
Oct
Sep
Sep
-0.2
104.7
2.0
-1.0
104.6
2.2
0.7
SE
US
US
US
Policy rate - %
New durable goods orders - % mom
S&P/Case Shiller house price index
Conference Board cons. confidence - index
Oct 28
Sep
Aug
Oct
0.25
-18
-0.5
86.0
0.06
1
0.1
86.7
00:50:00
08:45:00
19:00:00
19:00:01
21:00:00
JP
FR
US
US
NZ
BR
Industrial production - % mom
Consumer confidence - index
Policy rate - %
Fed asset purchases (USD bn per month)
Policy rate - %
Policy rate - %
Sep P
Oct
2.3
Oct 30
Oct 29
-1.9
86.0
0.25
15
3.5
11.0
0.25
0
3.5
11.0
30/10/2014
30/10/2014
30/10/2014
30/10/2014
30/10/2014
09:55:00
09:55:00
11:00:00
13:30:00
14:00:00
DE
DE
EC
US
DE
Unemployment - %
Unemployment change - thousands
Economic sentiment monitor - index
GDP - % qoq annualised
CPI - % yoy
Oct
Oct
Oct
3Q A
Oct P
6.7
12.0
99.9
4.6
0.8
6.7
3.8
99.5
3.0
0.9
31/10/2014
31/10/2014
31/10/2014
31/10/2014
31/10/2014
31/10/2014
31/10/2014
31/10/2014
00:30:00
11:00:00
11:00:00
11:00:00
13:30:00
14:45:00
14:55:00
16:00:00
JP
EC
EC
EC
US
US
US
MX
CPI - % yoy
Core inflation - % yoy
CPI - % yoy
Unemployment - %
Consumer spending - % mom
Chicago Fed - business confidence - index
Univ. of Michigan cons. confidence - index
Policy rate - %
Sep
Oct A
Oct
Sep
Sep
Oct
Oct F
Oct 31
3.3
0.8
0.3
11.5
0.5
60.5
86
3.0
3.2
0.9
0.4
11.5
0.1
60.0
85.7
3.0
ABN AMRO
0.1
105.2
2
87.0
0.25
0
3.5
100.1
3.0
0.8
0.9
0.4
11.5
Source: Bloomberg, Reuters, ABN AMRO Group Economics (we provide own forecasts only for selected k ey variables and events)
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Main economic/financial forecasts
GDP grow th (%)
2012
2013
2014e
2015e
+3M
+12M
2014e
2015e
2.3
2.2
2.2
3.8
United States
0.23
0.23
0.3
1.3
0.3
1.7
-0.6
-0.4
0.9
1.7
Eurozone
0.08
0.08
0.0
0.0
0.0
0.0
1.5
1.5
1.5
1.4
Japan
0.20
0.20
0.2
0.2
0.2
0.2
United Kingdom
0.7
1.7
3.0
2.8
United Kingdom
0.56
0.55
0.7
1.5
0.7
1.7
China
7.7
7.7
7.5
7.0
World
Inflation (%)
3.2
2012
3.2
2013
3.3
2014e
3.9
2015e
16/10/2014 23/10/2014
+3M
+12M
2014e
2015e
United States
2.1
1.5
1.7
1.6
US Treasury
2.15
2.28
2.6
3.1
2.6
3.3
Eurozone
2.5
1.3
0.5
1.0
German Bund
0.82
0.89
1.0
1.4
1.0
1.6
Japan
0.0
0.3
2.5
1.7
Euro sw ap rate
1.08
1.15
1.2
1.6
1.2
1.8
United Kingdom
2.8
2.6
1.6
1.7
Japanese gov. bonds
0.49
0.48
0.5
1.1
0.5
1.1
China
2.7
2.6
2.0
2.9
UK gilts
2.09
2.24
2.6
3.1
2.6
3.2
World
Key policy rate
4.1
23/10/2014
4.0
+3M
4.0
2014e
4.0
2015e
16/10/2014 23/10/2014
+3M
+12M
2014e
2015e
Federal Reserve
0.25
0.25
0.25
1.50
EUR/USD
1.28
1.26
1.25
1.15
1.25
1.15
European Central Bank
0.05
0.05
0.05
0.05
USD/JPY
106.3
108.3
115
123
115
125
Bank of Japan
0.10
0.10
0.10
0.10
GBP/USD
1.60
1.60
1.60
1.53
1.60
1.53
Bank of England
0.50
0.50
0.50
1.50
EUR/GBP
0.80
0.79
0.78
0.75
0.78
0.75
People's Bank of China
6.00
6.00
6.00
6.00
USD/CNY
6.12
6.12
6.17
6.25
6.17
6.25
United States
Eurozone
Japan
Source: Thomson Reuters Datastream, ABN AMRO Group Economics.
3M interbank rate
10Y interest rate
Currencies
16/10/2014 23/10/2014
5
Macro Weekly - Why deflation fears are overdone - 24 October 2014
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