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Opponents of quantitative easing (asset buying) have often warned of the inflationary threat brought about by central banks’ aggressive asset-buying programs. However, many major economies, namely the United States and Europe, are now in a period of falling inflation (disinflation). The danger of slipping into deflation (negative inflation) is now the more likely threat. The eurozone is leading the trend, with its year-over-year inflation rate having fallen from 1.1 percent in September to 0.7 percent in October. Deflation would harm investment, spending, lending, and employment, which would collectively weaken an already tepid global economic recovery. The European Central Bank and Fed must strike a balance between continuing quantitative easing (risking an asset bubble) and tightening monetary policy (risking deflation).
Key points in this Outlook:
“Everyone has a plan until they get punched in the mouth.” — Mike Tyson
Central banks have a plan: stay easy until the economy recovers and watch out for inflation. In short, get ready to tighten. Maybe in view of an alarming global drift toward deflation (a falling price level of goods and services), tepid growth, and stubbornly high unemployment, they should think about a different plan: get ready to ease more.
The European Central Bank (ECB), Fed, and their silly, hyperbolic critics have been so busy worrying about asset bubbles (hyperinflation) and how to exit aggressive programs of asset buying (“tapering” in the US jargon) that they have failed to notice a steady drift toward outright deflation. The October US consumer price index (CPI) rose at a 0.9 percent year-over-year pace, down sharply from the 2.2 percent pace from a year ago and well below the Fed’s target of 2 percent for inflation. (Of course there are other measures of US inflation, but all are falling. The Fed’s most preferred measure, the core personal consumption expenditure deflator, was at a 1.2 percent year-over-year pace in September, which was identical to the CPI rate that month.)
Europe Leads the Deflation Race
America’s steady trudge toward deflation notwithstanding, the leader in the global race toward deflation is Europe. At the end of 2011, Europe’s overall inflation rate was 3 percent year over year. By the end of last year, it had fallen to a 2 percent pace. In October, the euro area inflation rate dropped sharply to 0.7 percent from a 1.1 percent pace just a month earlier. The pace of core inflation dropped sharply as well, from 1.0 percent in September to 0.8 percent in October. If this pace of disinflation (falling inflation) continues, Europe could be living with outright deflation by next spring. That would very probably mean that Europe’s currently touted “recovery” would end as rising cash demands, real wages, and real interest rates depress demand and add to deflation pressure. A deflationary spiral, the inverse of an inflationary spiral, could well emerge. Third-quarter European growth, reported on November 13 at a miniscule 0.1 percent, is certainly not encouraging for those hoping for European reflation and recovery.
Outright deflation has already emerged in several small European economies—Bulgaria, Greece, and Latvia, in particular. Ireland has zero inflation, and inflation is at or below a 1 percent year-over-year pace for most other European Union countries save Romania, Slovakia, and Luxembourg, where inflation rates are just above 1 percent. Germany, Europe’s best performer, has seen its inflation rate drop sharply from 1.6 percent year-over-year in September to 1.3 percent year-over-year in October. Inflation in struggling Spain has dropped from a 0.5 percent year-over-year pace in September to a 0.1 percent year-over-year pace in October. (See figures 1 and 2 for the post-2008 trends.)
The ECB’s tight monetary policy, which causes disinflation to accelerate, and the fiscal austerity imposed on Southern Europe are the culprits in pushing Europe toward deflation. Germany, Europe’s engine of growth, is underperforming as an engine of demand. The US Treasury semiannual currency report, released on October 30, cited “Germany’s anemic pace of domestic demand growth and dependence on exports” as responsible for “. . . a deflationary bias for the euro area, as well as for the world economy.”
Another result of the drift toward deflation coupled with the austerity forced on most of Southern Europe is falling employment across Europe (see figure 3). Unemployment rates are stable to rising in Greece and Spain—the unemployment leaders—at 27.6 percent and 26.6 percent, respectively, contrasted with Germany’s much more modest 5.2 percent rate. The euro area unemployment rate is stuck at an awful 12.2 percent. Another recent ominous sign of deflation in Europe is the disappointing weakness of retail sales in Germany, where September sales fell 0.4 percent from August and are down to an anemic 0.2 percent year-over-year pace.
A self-reinforcing deflationary spiral that could emerge in a world of inadequate demand growth is a rare yet highly dangerous threat to a market economy. One usual remedy, like the one implemented by the United States in early 1933, is sharp currency devaluation. The 1933 dollar devaluation was driven by a US decree mandating a rise in the dollar price of gold from $20.67 per ounce to $35.00 per ounce. Since most currencies were pegged to gold in 1933, the 41 percent jump in the gold price amounted to a 41 percent dollar devaluation against other major currencies. The devaluation option is, however, unavailable in today’s world of floating exchange rates.
Without currency devaluation, the only remaining remedy for Europe’s demand drought—that is, precipitating a rapid drop in the price level and further increasing unemployment—would be sharply increased quantitative easing (QE), security purchases by the ECB, or tax cuts and faster spending growth for Europe’s governments. None of these remedies seem likely. Most of Europe is aiming at deficit reduction, spending cuts, and higher taxes, and the ECB has remained largely passive since ECB President Mario Draghi’s famous July 2012 assurance that the central bank would do “whatever it takes” to avoid having Europe slip back into recession.
The sharp drop in the euro area’s October inflation rate, which put the year-over-year core inflation rate at 0.8 percent—far below the ECB’s medium-term inflation target of 2 percent—prompted a November 7 cut in the ECB benchmark lending rate by 25 basis points to 0.25 percent. This response is largely symbolic as there is little evidence that effective lending rates to already passive European borrowers will be much impacted. It is more likely that little, if any, new borrowing or financial activity will result.
Underscoring the ECB’s dilemma, after the ECB rate cut precipitated a rally in European stocks and bonds, 6 members of the ECB’s 23-member governing council made it clear that they disagreed with the decision to cut rates. They complained, plausibly, about the increased risk of financial bubbles and, implausibly—in view of Europe’s steadily falling inflation rate (see figure 2)—about the increased risk of inflation of goods and services prices.
The Bubble-Deflation Dilemma
QE and other monetary experiments such as pushing interest rates to zero have left most major central banks, including the ECB and Fed, facing a dilemma. If QE is pushed too far, asset inflation (bubbles) arise and central banks must continue easing to avoid a disruptive bursting of bubbles. Such bursting could precipitate a return to recession and even a financial crisis. Figure 4 shows the rapid rise in asset prices compared to the tepid rise of price levels in the United States and Germany since November 2008. Eventually, inflated bubbles will boost spending enough to cause inflation, but none is yet evident. In fact, the contrary problem of disinflation drifting toward deflation is more evident. In October, the International Monetary Fund World Economic Outlook estimated inflation for 2013 at 1.4 percent for advanced economies, down from a prediction one year prior of 1.6 percent.
Given persistently spreading and accelerating disinflation, removing QE or raising interest rates would elevate the risk of outright deflation. A passage over the monetary cliff from disinflation to deflation threatens a self-reinforcing deflationary spiral. A rapid drop in prices threatens growth by boosting real interest rates (which would reduce investment), real wages (which would reduce employment), and cash holdings. All of these results further accelerate the pace of deflation. Unfortunately, deflation begets more deflation.
The Global Deflation Threat
The world’s major central banks all face a deflation threat. The Bank of Japan is pushing to end Japan’s decade-long deflation, having articulated a 2 percent inflation target accompanied by aggressive QE that has already turned a 1.5 percent deflation rate into a zero deflation rate. Other central banks will need to follow Japan’s lead by coordinating higher asset purchases aimed at boosting demand growth while avoiding the sharp currency movements that would result if only one central bank pursued aggressive monetization. If inflation expectations were boosted globally, real interest rates and real wages would fall and global demand growth might start to recover.
Central banks—especially the ECB—need to, for the time being at least, stop worrying about possible asset bubbles and possible future inflation and start worrying about the approach of deflation. The Fed’s tiresome game of taper ping pong is increasing the chance that the US economy will stagnate as underlying monetary and fiscal drag pull the growth rate below a 1 percent pace. The ECB needs to recognize that its mandate is price stability. That means avoiding outright deflation as well as avoiding high inflation.
Additionally, central banks would do well to begin talking about what they would do if the global economy became weaker than expected instead of only talking about how they would withdraw stimulus if the economy gets stronger. Otherwise, they might get a nasty punch in the mouth in 2014.
1. See John H. Makin, “Forget Tapering, and Get Ready for QE4,” Real Clear Markets, September 4, 2013, www
2. See, for example, Andrew Huszar, “Confessions of a Quantitative Easer,” Wall Street Journal, November 11, 2013, http://online.wsj.com/news/articles/SB10001424052702303763804579183680751473884.
3. US Department of the Treasury, Office of International Affairs, Semiannual Report on International Economic and Exchange Rate Policies (Washington, DC, October 30, 2013), www.treasury.gov/resource-center/international/exchange-rate-policies/Documents/2013-10-30_FULL%20FX%20REPORT_FINAL.pdf.
4. International Monetary Fund, World Economic Outlook: Transitions and Tensions (Washington, DC, October 2013), www.imf.org/external/pubs/ft/weo/2013/02/.
5. See John H. Makin, “Beware the Monetary Cliff,” AEI Economic Outlook (November 2013), www.aei.org/outlook/economics/monetary-policy/federal-reserve/beware-the-monetary-cliff/.
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