This article was originally published 19 November 2014 on ft.com.
Japan shows costs of acting too late on deflation risk
Here is a thought experiment. What do you think inflation is going to be in the US or the UK seven years from now? While we believe it is not possible, in any serious way, to forecast annual inflation that far ahead, the most sensible answer is 2 per cent: the Federal Reserve’s and the Bank of England’s inflation targets. These are credible central banks.
What about the eurozone? Is the European Central Bank’s inflation target of close-to-but-below 2 per cent credible? That is not so clear. Mario Draghi, ECB President, is right to highlight the decline in longer-term inflation expectations in the eurozone as a worrying development that demands action.
To the extent that the eurozone has a growth strategy, it is to hope for external demand to propel exports. But Asian demand has weakened. The Ukraine-Russia crisis will affect eurozone growth. Eurozone domestic demand growth is depressed. Fiscal policy is less of a drag, but countries with room for fiscal expansion are reluctant to use it.
While the eurozone may avoid a third technical recession, in practical terms it has not emerged from the recession that started in 2008. If you apply the same criteria to the eurozone that the US National Bureau of Economic Research uses for judging US business cycles, then this realisation is very clear. In this context, it should be no surprise that the eurozone is so close to deflation.
In the year to October, eurozone headline inflation came in at 0.4 per cent. In December, the ECB is going to have to revise down its inflation forecasts again – something that has become a quarterly ritual. It will be interesting to see if the ECB has enough confidence to forecast inflation at 2 per cent in 2017, when it adds the third year to its forecast.
This is not just a matter of adjustments needed in peripheral countries: inflation is dangerously low in the core, too. Nor is it just a matter of lower energy prices. Core inflation, excluding food and energy, was just 0.7 per cent in the year to October. While certainly not complacent about the ECB’s inflation target, Mr Draghi is constrained by eurozone co-ordination problems and a recalcitrant Bundesbank. Still, he has been able to build a strong case for action, based on the risk to medium-term inflation expectations and explained in terms of the size of the ECB balance sheet.
The ECB is already engaged in quantitative easing (QE) via its covered bond purchases and the planned purchases of asset-backed securities. But these are likely to be small programmes, and the same would apply if the ECB bought corporate credit. The most practical way to expand its balance sheets via asset purchases is by buying government bonds, just as the Fed and BoE did.
QE would certainly be more powerful if combined with fiscal expansion, where possible. And structural reform is needed to promote higher potential growth rates in the medium term to ensure long-term eurozone stability. These are important matters. But the ECB consists of unelected officials with a mandate based on inflation. It should act in the area it controls.
One of Mr Draghi’s signal achievements has been to demonstrate that the ECB is indeed Europe’s central bank, and that its decisions are not subject to any one country’s or regional central bank’s veto. The ECB reportedly started the latest covered bond buying programme without the vote of the Bundesbank. It may do the same if it starts sovereign QE.
Mr Draghi’s July 2012 pledge to do “whatever it takes” to prevent a rolling eurozone sovereign debt crisis worked without the ECB having to do much other than make clear that it will act in the interests of the eurozone as a whole. We expect continued eurozone stability in the next 12 months and see peripherals, notably the liquid Spanish and Italian markets, as offering an attractive source of credit risk. But sustainable debt dynamics in the medium term will require healthy nominal GDP growth.
Returning to the initial thought experiment, ask yourself: what do you expect for Japanese inflation seven years forward? Even with the Bank of Japan’s clear resolve in recent years – and recent huge increase in its QE programme – it is not at all clear. Years of neglect allowed a deflationary public mindset to become entrenched.
The eurozone is one shock away from sinking into deflation. There are real costs of acting too late.