EU Economy
Impact of euro QE in a deflationary world
By Michael Hennigan, Finfacts founder and editor
Jan 8, 2015 - 8:50 AM

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The flash estimate on Wednesday from Eurostat, which showed that annual euro area inflation had fallen by 0.2% in December 2014, makes a European Central Bank announcement of a quantitative easing (QE)/ sovereign bond buying program a near certainty on January 22 when the governing council will hold a policy meeting. However, deflationary trends exist also in many parts of the world.

Martin Wolfe of the Financial Times wrote (via Irish Times) on Tuesday: "since long-term interest rates are low, private sector balance sheets are stronger and fiscal deficits are under control. If the European Central Bank pulled out all the stops, the rise in confidence might surprise."

Alberto Gallo, head of macro credit research at RBS, writes today: "Lower government bond yields will not benefit Europe’s smaller companies, which create more than 80 % of new jobs. While such firms can borrow via capital markets in the US, in Europe they rely mostly on banks for credit...As for the wealth effect, QE works. The problem is it benefits the wealthiest households that hold most financial assets, but are also less willing to spend the marginal gains. An ECB working paper from March 2014 estimates the top 10 % of the population is three times less likely to spend following a gain in wealth than the bottom 50 %. After six years of rising unemployment and declining wages, it is unlikely that QE will push Europeans to go on a spending spree."

Gallo acknowledges that the fall in the value of the euro will at least on a temporary basis boost exports and he calls for a) more investment by core countries as the Juncker €315bn infrastructure plan is not credible b) he says regulators should harmonise rules about bank lending and c) Greece's debt should be restructured.

Economists do not regard deflation as simply falling prices as the key trigger is a cutback in consumer and business spending as prices are expected to fall further.

“For me, a few months of inflation rates below zero does not constitute deflation. That would require a self-perpetuating downward spiral of negative inflation rates, GDP declines and wage declines,” Jens Weidmann, president of Germany’s Bundesbank and a member of the ECB’s governing council, said late last year  according to The Wall Street Journal. “This risk remains minimal.”

However, in an interview with the Börsen-Zeitung published as 2014 drew to a close, Peter Praet, ECB chief economist, warned that prices may fall “during a substantial part of 2015.” Unlike Weidmann, he doesn’t believe that can be ignored, since “inflation expectations are extremely fragile.”

In the FT, Bilal Hafeez, a managing director of Deutsche Bank, writes that data for 30 countries back to the early 1800s show that "Europe has seen higher growth during deflations than inflations. In the past, Germany has done especially well out of falling prices, growing at 2.6 % during deflations against a measly 0.6 % when prices were going up.

This is not to say that people living through deflationary times — or through periods of inflation for that matter — have always had good experiences. From a macroeconomic perspective, though, the long-term historical record is mixed."

As we noted in our articles on the commodities supercycle, not only did oil price benchmarks fall by almost half in 2014 but global food prices also declined.

China is slowing after decades of blistering growth; the Russian economy will contract this year and Brazil on Monday posted its first annual trade deficit in more than a decade for 2014 due to a global commodities slump and an economic downturn in neighbouring Argentina, the biggest foreign market for Brazilian-assembled vehicles.

In Japan on Wednesday, Shinzo Abe, prime minister, said deflation could end this year after promises from business lobby groups to raise wages - however, they prefer hoarding cash and have built up reserves from the windfalls triggered by the decline of the yen.

Japanese firms, excluding insurers and financial companies, had a record ¥313tn ($2.65tn) in excess reserves at the end of June, according to the ministry of finance. The nation’s largest company by market capitalisation and profits, Toyota Motor Corp. , expects to earn ¥2tn (about $17bn) this fiscal year which ends in March.

The Bank of Japan's target inflation rate from its massive QE is 2% by April but that will be missed.

Japanese wages adjusted for inflation fell the most in almost five years in November 2014. Real earnings dropped 4.3 % from a year earlier, a 17th straight decline and the steepest tumble since December 2009, the Japanese government said last month

The Japanese government expects real economic growth of around 1.5% next fiscal year, based on the assumption that consumer spending and capital investment will recover.

Core consumer price index (CPI), which excludes volatile fresh food but includes oil products, rose 2.7 % in November from a year earlier. Excluding the effects of a sales tax hike in April, core consumer inflation was 0.7 %, slowing from 0.9 % in October

Brazil on Monday posted its first annual trade deficit in more than a decade for 2014 due to a global commodities slump and an economic downturn in neighboring Argentina, the biggest foreign market for Brazilian-assembled vehicles.

Size of ECB's QE

Mario Draghi, ECB president, said last September that the central bank aimed at moving the ECB’s balance sheet towards its size at the beginning of 2012, around €2.7tn compared with a current level of €2tn.

George Saravelos of Deutsche Bank in an October 2014 report argued that both 'secular stagnation' and 'normalization' are incomplete frameworks for understanding the post-crisis world. Instead, 'Euroglut'  – the global imbalance created by Europe’s massive current account surplus will be the defining variable for the rest of this decade. Euroglut implies three things: a significantly weaker euro (we forecast 0.95 in EUR/USD by end-2017), low long-end yields and exceptionally flat global yield curves, and ongoing inflows into 'good' EM assets. In other words, we expect Europe’s huge excess savings combined with aggressive ECB easing to lead to some of the largest capital outflows in the history of financial markets."

So instead of investments in Europe, funds will flow elsewhere!

On the day the Eurozone officially dropped into deflation, John Authers looks at growing market worries about disinflation in the US. Will the oil price fall prove to be transitory?

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