We believe deflation risks in the Euro area will be a major theme during the second half of this year. Deflation risks are a question of how much slack there is in the economy or, in academic terms, a question of the size of the output gap. The problem with the output gap is that it cannot be observed. We take a deeper look at the deflation risks by constructing a number of scenarios for the output gap and compare the predicted levels of inflation, wage growth and companies pricing power since 2009 with the actual readings. The results of our work is attached in presentation format accompanied by the text below.
Cyclical or structural problems?
The bigger the output gap – the slack in the Euro area – the higher the risk of deflation if monetary and fiscal policies are not eased aggressively enough, soon enough. This is the risk of a Japanese scenario.
However, if the jobs lost during the crisis are predominantly in sectors that have suffered a permanent loss of activity, say the construction-related sectors in Spain or Ireland, and the unemployed cannot take up a job in growing sectors, say the German service sector, there is little downward pressure on wages despite the high level of unemployment. The output gap is small. The ECB cannot do much more and fiscal easing will not help. Structural reforms will be the only way to return to growth, and austerity will be needed to repay debt. Deflation risks are small and inflation risks could return if policies are kept too easy for too long.
Various institutions such as the European Commission, the OECD and the IMF spend a lot of time setting up economic models for estimations that all suggest that the output gap is big.
If the output gap is really that big, the deflation risk is real. In this case, the growth potential is still there and the problem is lack of demand, lack of confidence among households and companies. Fiscal and monetary policies should be eased much more for the Euro area to return to growth. And the return to growth – not austerity – will help bring down debt. Structural reforms are of secondary importance.
Putting Draghi to the test
The ECB seems to put less emphasis on economic models and more emphasis on actual data. In January ECB President Draghi said that if the output gap was really that big, inflation would have been lower!
We tend to agree with Draghi but have decided to test his statement.
To test Draghi we construct four scenarios for the output gap. Roughly speaking, we make one scenario that reflects the ECB’s apparent belief that the output gap is small, one scenario reflecting the IMF and the European Commission’s projections that it is big, one scenario reflecting the OECD’s scenario that it is very big and one scenario using a historical growth average pointing to a huge output gap.
We then look at core inflation, wage growth and companies’ pricing power and compare the actual readings with in-sample forecasts based on the various output gap scenarios. In that sense, we look at how big the actual data would suggest the output gap to be.
Deflation risks are small but rising
The conclusion supports the ECB view. Actual data suggest that the output gap is not that big. That could be the reason why the ECB has not been as aggressive as the Fed, the Bank of England or more recently the Bank of Japan. However, the conclusion is also that data over the past six months or slightly more point to a bigger output gap. Core inflation has come down significantly, wage growth has been volatile but slowing and companies are passing on less of the increase in input prices to consumer prices. This could be the reason for the ECB’s turnaround in May, when it cut interest rates with roughly unchanged projections for growth and inflation compared with December last year.
If, going forward, more data support the view of a growing output gap, there will be a real risk of deflation and we believe we will see a much more aggressive ECB. And, obviously, normalisation of interest rates is years away. For now we see deflation as a risk scenario.
A few thoughts on the markets
There are numerous market implications even if we do not believe deflation risks are that big (though increasing). We expect headline inflation (HICP ex tobacco) and core inflation to print lower in the second half of the year, and with a continued weakening of the labour market, deflation is likely to become a major theme. That is likely to lead to even lower implied inflation, especially on shorter horizons.
A substantial drop in implied inflation in longer maturities, say 10Y, would be a sign that markets are losing confidence in the ECB and starting to price in deflation risks.
More evidence of increasing deflation risks is likely to prompt a much more aggressive ECB. When nominal (market) rates are zero already, the next easing step is to push up inflation expectations and thereby lower real rates. For the ECB this step would most likely be forward guidance and potentially in the form of a temporary price level target. In this case, implied inflation, say 3-5 years ahead, could actually rise above 2%.
The Bank of Japan recently increased its inflation target to push up inflation expectations and lower real rates. So far, markets have done exactly that. But nominal yields have actually increased! This suggests that real rates have much bigger downward potential than nominal rates in the Euro area.
Read the full report: Economic Research
Nordea