What a difference eight weeks can make. Until late January, international observers seemed to be worried stiff about the risk of Eurozone deflation. Now, the subject hardly comes up any more in discussions. What has changed?
It can’t be the actual inflation data. After a -0.6% print for January, headline inflation still came in at -0.3% yoy in February. In a technical sense, the Euroztone is actually in defaltion. On average, prices are lower than they were a year ago.The mischievous explanation why international observers no longer seem to worry much is that we learned on 26 February that even the US has now fallen into modest deflation, with a 0.1% yoy drop in US consumer prices in January. That may have silenced some of those commentators who thought that the Eurozone is afflicted by some disease that may befall benighted economies such as Japan or the Eurozone but not well-managed ones such as, supposedly, the US or the UK.
The more relevant explanation is probably that the European Central Bank finally got its act together, brushing aside Bundesbank objections to focus on its job to steer inflation gradually back to the desired „below but close to 2%“ level. More than most of their European counterparts, US investors have been imbued with the wisdom „don’t fight the Fed“. With the ECB finally stepping up to the plate on 22 January, they seem to trust the ECB to scare away the deflation spectre.
Whatever the reason for the apparent change of heart among many international observers, we are happy about the end result. The deflation scare never made much sense. So far, all the available data for the Eurozone have supported our view of the debate: the decline in inflation has been good rather than bad for the Eurozone. Low prices for oil imports leave consumers more money to spend on other goods and services. In line with the decline in inflation rates throughout 2014 and the fall into negative territory in early 2015, the readiness of Eurozone consumers to make major purchases surged in January and February to its highest level since the boom times of late 2006 according to the European Commission’s monthly consumer confidence survey. And consumers seem to be putting their money where their mouth is. Eurozone car sales rose 13.5% year-on-year in February after a 7.0% yoy gain in January. Mild weather probably helped, but it still remains a solid gain. In a similar vein, the 3.7% yoy gain in retail sales in January has been the strongest result since the summer of 2005.
Eurozone consumers are rational, just like their Swiss counterparts: when prices look attractive, they buy. There is no trace in the data of consumers delaying purchases to wait for lower prices.
But what about debt deflation? As we have argued time and again, this is a theoretical risk but not an issue in the Eurozone. Yes, an unexpected shortfall in nominal income caused by unexpectedly low inflation does make it more difficult to eventually repay a debt burden that is fixed in nominal terms. But this can be more than offset by a corresponding decline in financing costs. Real financing costs (deflated by core inflation as we would otherwise count a drop in import prices as an impediment to servicing domestic debt) have come down sharply across almost the entire Eurozone apart from Greece.
Ultra-low inflation has given the ECB the political opportunity to pursue a much more aggressive and appropriate policy. In addition, a long period of low inflation reduces the inflation risk premium in real yields, bringing financing cost down even further. Thanks to very low real financing costs, debtors in the Eurozone can bear their debt now much more easily even though the real value of the nominal debt is no longer eroded by inflation. Just think what wonders the fall in Italian 10-year yields from 7% in late 2011 to 1.2% now can do to all calculations about debt sustainability.
Let’s hope that the debate about imaginary risks of a dangerous deflation spiral in the Eurozone is over for good. It never made much sense. Of course, the Eurozone still has serious issues such as trying to tame a Tsipras in Athens and nudging Hollande further onto the path of Spanish-style reforms. But deflation never was one of these concerns.