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Macro Weekly: the dark forces of deflation threaten the European recovery

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As survey data continues to soften, deflation risk becomes a key topic in the current policy debate in the Eurozone. November flash CPI releases during the week will give us hints about how serious the deflation threat is. We believe it is and the ECB may have to deploy more unconventional tools to fight it. 

Last week, several data releases confirmed the view that the Eurozone recovery may be stalling, with Germany being the usual notable exception. This makes the ECB’s job harder, as the German public (and their elected representatives) does not feel the pinch from a deflationary environment in the rest of the continent (yet).

Key ECB policymakers acknowledge deflation risk

The week was dense with speeches from key policymakers. In our view, the tone is clear: the ECB is very worried about a deflationary spiral and is willing to do “whatever it takes” to fight avoid it. Let’s review some key quotes from last week to better frame the current debate around monetary policy in Europe:

  1. Speaking in Frankfurt last Friday, ECB’s president Draghi said (link to the full speech here):

    “our mandate is inherently European – it is to maintain price stability for the euro area as a whole. And this mandate is symmetric; don’t forget that price stability works in both directions. We need to act as much when there is a risk that inflation in the medium term might become too low as well as too high.
    As I had the opportunity to explain yesterday, when we took our recent decision to cut interest rates, we saw a situation where the inflation outlook deviated too strongly away to the downside from our price stability mandate. Our decision was necessary to comply with our mandate.

  2. On the same day, ECB’s chief economist Peter Praet was at a Bank of France event. There he said:

    “This is a very different context for the correction of expectations (about income), which is more of a debt overhang. [...] It has more signs of a balance-sheet recession, which is a priori more of a deflationary environment than what we had in the 1960s.”

  3. In an opinion piece on the WSJ titled “The ECB is ready to fight deflation“, Bank of France governor Noyer wrote:

    “In some peripheral countries, inflation is particularly low. This, in a way, is a good thing, as it contributes to restoring their competitiveness, as witnessed by their strong export growth. However, the lower inflation is, the greater the risk that unexpected shocks could push the economy into deflationary territory. Since this could, in turn, have consequences for overall euro-area inflation, it is perfectly justified to ask what should be done to minimize that risk.”

Even if the official line is that inflation expectations remain well anchored, deflation is starting to feature regularly in all policymakers’ public appearances. At the November policy meeting, the ECB took the market by surprise by cutting its main interest rate but we believe that alone will be insufficient to change the course of monetary dynamics.

Is the deflation risk real?

We believe the risk is real and imminent. There are strong forces at work that are pushing the old continent towards deflation, and the ECB needs to acknowledge them all and fight them appropriately. These include:

  • Deleveraging. The European banking system is still not functional. Cross border interbank lending has not resumed to the full, capital soundness is still being questioned by some market participants and even healthy banks are still taking a cautious approach to lending due to the uncertainty around regulatory requirements. The experience of the past few years has thought bank management that it’s better to err on the side of caution when it comes to capital, as shareholder value has been decimated by the several capital increases that the banks had to undertake. This is a good lesson that hopefully will limit moral hazard in the long term, but in the short-term it’s squeezing businesses (especially SMEs that rely mainly on banks for their finance) and exacerbating the recessions.
  • Imported deflation via a strong euro. US, UK and Japanese efforts to prop up their economy with monetary policy translate in a weakness of their currencies vs the Euro. As a result, the Eurozone is effectively importing deflation from its trading partners. This is due to the ECB’s strict mandate. While it gives the central bank credibility as an inflation fighter, it leaves the bloc exposed to competitive devaluations. There is a currency war out there, but the ECB’s rules of engagement do not allow it to fight back.
Macro data wrap-up: more softening in survey data, with the notable exception of Germany

During the week, PMI and confidence data for November confirmed a softening in the growth outlook for the Eurozone; moreover, Markit PMIs, Ifo and ZEW releases show that Germany is still steaming ahead, which makes the job of policymakers in Frankfurt even more difficult.

  • Eurozone’s  PMI composite output index estimate for November fell to 51.5 from 51.9 in October. While this continues to signal expansion, there is a clear slowdown in the pace of recovery and the fear is that it may signal a triple dip. The drop was driven by services, while manufacturing registered a small improvement. Notably, both services and manufacturing PMIs for Germany improved compared to the previous month, beating economists’ expectations. French PMIs, instead, disappointed expectations and dropped sharply. Both manufacturing and services PMIs are now below the 50 point threshold (47.8 and 48.8 respectively), signalling economic contraction;
    Markit PMI in November confirm a slowdown in the pace of recovery
  • Eurozone Consumer confidence is still negative (-15.4) and worsening compared to October (-14.5)
  • the German Ifo business climate indicator jumped to 109.3 in November after pausing for breath in October (107.4), signalling German businesses are still positive on Germany’s outlook. Similarly, German investors remain confident, with the ZEW survey showing economic expectations improving both for Germany (+1.8 to 54.6) and for the Eurozone (+1.1 to 60.2).
In focus next week: Inflation and Monetary Developments, Unemployment

On Friday, Eurozone flash CPI estimates for November will be released (preceded by German and Spanish CPI on Thursday). Given the shock-low reading for October, the ECB’s reaction and the whole debate about deflation risk this will be by far the most important data point of the week, in our view. Together with the key release on monetary developments in October (on Thursday) and with the unemployment data to be published during the week, these are in practice the three drivers of the ECB’s reaction function, as explained by Mr. Draghi on several occasions when discussing forward guidance.

Data on consumer and business confidence, both at the Eurozone and at country level, will be released during the week, giving us further visibility into the seriousness of the recent slowdown.

Weekly calendar of economic releases: 25 November – 29 November 2013

(all times refer to Central European Time – CET)

Monday 25th Nov.

08:45 a.m. – France, Business Climate Indicator (November)
09:00 a.m. – Spain, Producer Prices (October)
10:00 a.m. – Italy, Trade Balance with non-EU Countries (October)

Tuesday 26th Nov.

10:00 a.m. – Italy, Consumer Confidence (November)

Wednesday 27th Nov.

08:45 a.m. – France, Consumer Confidence (November)
09:00 a.m. – Spain, Retail Trade (October)
10:00 a.m. – Germany, GfK Consumer Climate Index (December)

Thursday 28th Nov.

08:00 a.m. – Eurozone, New Commercial Vehicle Registration – ACEA (October)
08:00 a.m. – Germany, Unemployment Rate (October)
08:00 a.m. – Germany, Import and Export Prices (October)
09:00 a.m. – Spain, Consumer Price Index – flash estimate (November)
09:00 a.m. – Spain, Gross Domestic Product (Q3 / 2013)
10:00 a.m. – Eurozone, Monetary Developments (October)
10:00 a.m. – Italy, Business Confidence (November)
11:00 a.m. – Eurozone, Business and Consumer Survey (November)
11:00 a.m. – Eurozone, Business climate indicator (November)
11:00 a.m. – Italy, Large Firms Labour Indicators (September)
12:00 p.m. – OECD, Quarterly Trade
02:30 p.m. – Germany, Consumer Price Index – flash estimate (November)

Friday 29th Nov.

08:00 a.m. – Germany, Earnings (Q3 / 2013)
08:00 a.m. – Germany, Retail Trade (October)
08:00 a.m. – Germany, Wholesale trade (Q3 / 2013)
08:45 a.m. – France, Household Consumption Expenditure (October)
08:45 a.m. – France, Producer Prices (October)
10:00 a.m. – Italy, Unemployment Rate (October)
11:00 a.m. – Eurozone, Unemployment Rate (October)
11:00 a.m. – Eurozone, Consumer Price Index – flash estimate (November)
11:00 a.m. – Italy, Consumer Price Index – flash estimate (November)
12:00 p.m. – Italy, Producer Prices (October)

By Valeria Palumbo, Marco Troiano

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  1. The OECD is worried about deflation in the eurozone too, but at the same time says that it has helped eurozone periphery countries to rebalance somewhat. How do you reconcile the two issues? Will the periphery countries continue rebalancing if the ECB takes drastic measures to fight deflation, such as joining the currency war? The OECD’s Gurria also warns that there’s too much regulation hitting the banks: http://www.marketmoving.info/eurozone-imbalances-are-being-corrected-oecd/

  2. Marco Troiano says:

    the way I see it: the competitiveness gap between south and north needs to be rebalanced via an inflation differential. The choise is whether this will come through higher inflation in Germany or deflation in the South. So far, policy has pushed for the first option. Now, it looks like they are acknowledging they went too far and will likely pull in the opposite direction.

  3. The moves by the ECB (and the central bank in Japan) to weaken the currency through looser monetary policy seem like part of measures to bolster inflation by increasing the prices of imports. This is just creating inflation for inflation’s sake and is likely to be worse than any deflation which is necessary for some countries in Europe to regain competitiveness. For more, see http://yourneighbourhoodeconomist.blogspot.com/2013/11/good-deflation-better-than-bad-inflation.html

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