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Economy in Brief

EMU Inflation Burrows Lower across the Board
by Robert Brusca  January 14, 2015

As we peruse the incoming data, we see new inflation reporters and a new EMU index for industrial production. EMU-wide inflation is still falling and negative year over year. While industrial output is still on a big broad decline, manufacturing output is up in each of the last three months.

Today, U.K. Prime Minister David Cameron, expressed the view that deflation was not to be feared. This is a 100% turn abound from the Saturday Night Live skit in which Dan Aykroyd, doing his impersonation of Jimmy Carter, launched the famous skit, `Inflation is your friend.' Neither inflation nor deflation is your friend unless you have peculiar circumstances.

Still, Chancellor of the Exchequer George Osborne offered this observation: "The low inflation we see here in the U.K., driven as it is almost entirely by external factors such as the oil price, is much more welcome than in the euro zone where inflation has been very low for some time and is now negative" (Source here).

We have heard others in the U.S., notably Philadelphia Fed President Charles Plosser, express a somewhat similar view. To me, it is not about deflation, but as Cameron observes what has caused deflation to emerge. On this ground, I am much less reassured than Cameron. The U.K. is still plugged into the weak global economy and, since Scotland stayed `in', the U.K. still has oil and the sector will suffer from dropping prices.

Low wage countries largely in Asia have been depressing wages in the high-income/high-wage West for some time. Asian economies have grown especially strongly in the last 30 years but have not had higher wages or even better consumption as an emphasis. They have tended to be much higher savings economies. China has been the best (worst?) example of this. It has hoarded production and minimized increases in consumption. As businesses has shifted from the West to a production base in Asia, workers with a high consumption tendency have been replaced by workers with a low consumption tendency leading to this situation of global excess supply. That is still in force, Mr. Cameron.

Europe has a bit more of this bug because of home grown problems that add to the international pressures. In the table below, we show how much competitiveness has been lost within the EMU by various member states to Germany. Since the EMU formation, German prices are up by only 26.8% compared to a rise of 29.6% in France, the closest to Germany's performance. Price levels are up by over 40% in Luxembourg and in Spain, and by 39% in Portugal. Enormously different national inflation rates have created this situation, something the European Central Bank was not chartered to monitor. But maybe it should have been paying attention?

The final two columns of the table show how various reporting EMU members have improved their competitiveness vis-a-vis Germany from its worst divergence. Greece, which has had the most dislocation, has seen its inflation divergence fall from a peak of 46.9% to have a price level only 10% higher than Germany's compared to when Greece was let into the Monetary Union. All countries in the table have made competiveness gains, most of them quite significant. However, remaining competitiveness differences linger. Spain and Luxembourg still have price levels that are 17% to 18% above those in Germany compared to what they were when the EMU launched the single currency. Overall EMU divergence with Germany is down to 6.3% on weighted average terms from 9.4% at its worst.

Significant divergence remains. But today the European Court of Justice provided a ruling that will let the ECB go ahead with a plan to purchase sovereign bonds and engage QE in the euro area. Jens Weidmann of the Bundesbank, among other Germans, had protested that this was an act disallowed by its charter but they have lost and the Draghi plan to launch QE will take shape. This may boost growth and help countries that are struggling with deflation to be able to grow somewhat better. Right now with Germany seeing its inflation up by only 0.1% year-over-year, any country wanting to gain competitiveness vs. Germany will have to run a policy of deflation. In the table, six of the members have prices falling and one has prices unchanged year over year.

Europe's inflation divergence is at the heart of its uneven economic performance. David Cameron is right to distance the U.K. from that. But global slack and the still cheaper wage environment across Asia will keep deflationary forces in place. Central banks around the world in monetary center countries have taken extraordinary actions to try to mitigate these effects that became more intense in the post-financial crises and the post-recession global economy. But even as oil prices are falling, circumstances are not heating up. The World Bank has just cut 0.4 percentage points of growth off its forecast. And it is expecting the U.S. economy to be still-strong. However, we need to factor in current trends since the euro area is getting a real boost from ongoing weak euro while the U.S. is being buffeted by a rising dollar in addition to the hit to its energy sector in the wake of plunging energy sector prices. There are severe cross-currents in 2015. New reports are now saying oil price may have to go to $40/barrel and stay there to deter some of the alternative energy producers.

Do not ink in a growth number for 2015 just yet. Moreover, do not bet too heavily on the ECB's newly allowed plan for QE. The new ruling does put some constraints on it and we still think there is enough opposition to keep the program from being too large and really effective. Europe may not be out of the woods yet even with the favorable ruling on QE.

As for deflation, deflation per se is no problem but the transition to deflation from an environment of inflation - unless very well prepared for - is a problem. People currently have too much debt to prosper under deflation. In deflation, your debts are not reduced by inflation; they become more burdensome. Deflation will therefore cause consumers to spend less and pay down debt even more if they think the deflation will last. Also deflation is not just a thing; it is a symptom. In this case, it is a symptom on ongoing weak global demand and of foreigners working for lower wages. Those factors further eviscerate Western incomes and wages. We do not see such a quick rebound in 2015. We think the U.S. attempt to mount jackrabbit growth will soon fade and be back in the 2.5% to 3% mode. That won't be much to drive a still limping global economy.

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