Euro Area Deflation and Risk for UK Economy May 2014

Question 1

Do you agree that there is a significant risk of a sustained deflation across the Euro Area in the coming two years?

Question 2

Do you agree that a deflation in the Euro area (as defined in Question 1) would pose a considerable risk to the UK recovery?

Summary

Although Eurozone inflation has persistently surprised on the downside and has been below 1% since October 2013, the UK macroeconomics profession is not convinced that this heralds a deflation. In the second monthly survey by the Centre for Macroeconomics (CFM), summarised in this column, a small majority of respondents do not think there is a significant risk of Eurozone deflation in the next two years. But nearly two thirds of respondents to the CFM survey think that sustained Eurozone deflation would pose a significant threat to the UK recovery.

This month’s first question concerned the severity of the deflation risk facing the Eurozone. Although many economists felt that the deflation threat was tangible, the balance of probabilities was that European Central Bank (ECB) policy would be loosened sufficiently to prevent a deflation and this was probably reflected in measured inflation expectations, which remain close to the ECB’s target.

This month’s second question concerned the likely impact of any Eurozone deflation on the UK’s economic recovery. To the extent that a sustained Eurozone deflation might occur, economists identified several possible avenues that threatened the UK recovery, ranging from net exports, economic and political uncertainty, through to the impact on the balance sheets of financial institutions. But note that a significant minority did feel that the UK recovery was strong enough to withstand a further contractionary impulse from the Eurozone.

Deflation risks facing the Eurozone

The first question centred on the immediate risk of a Eurozone deflation. The annual rate of change in the Eurozone HICP (Harmonised Index of Consumer Prices)[1] was estimated at 0.5% in March 2014 and has been below 1% since October 2013. Despite this dip in measured inflation, inflation expectations do not suggest any widespread concern about deflation. For example, the mean of longer-run inflation expectations from the ECB’s survey of professional forecasters is 1.9%; the mean of short-term inflation expectations is also above 1%; and long term forecast measures obtained from financial prices also remain above 2%.[2]

But it has been argued by some commentators that sluggish growth rates in many Eurozone countries will have the scope to trigger a surprise deflation, perhaps similar to what has happened in the past in Japan. 

For the question, we suggested to respondents that they define the risk of an event as “significant” if their subjective probability of the event exceeds 25% and “sustained” as corresponding to a duration of at least two quarters (and probably more) in succession of negative annual CPI (consumer price index) inflation across the Eurozone. And we suggested that they might wish to employ their own numerical definitions, and explain any such definition in their commentary.

Survey results on Eurozone deflation

The survey produced finely balanced results but with a small majority inclined to think that the risk of a deflation was not significant. While 54% of respondents disagreed (43%) or strongly disagreed (11%) that there was a significant risk of a sustained Eurozone deflation over the next two years, if we weigh the responses by the degree of certainty, the overall majority disappears.

The NIESR’s latest forecast, summarised by Angus Armstrong, does project a significant risk of deflation as it “ha(s) Euro Area inflation of 0.1% to 0.2% in the third and fourth quarters of this year as a central case, (meaning that) (d)eflation, as defined, would certainly fall within a 25% probability around this central case. The critical question would then become what happens to expectations, which in some part depends on the ECB.”

Chris Pissarides (LSE) captured the mood of many respondents by arguing that, “(i)f the ECB continues with its current policies there will be a significant risk of sustained deflation. But recent talk from the ECB indicates that they are aware of the risks. A change of ECB policy can surely avert deflation so my expectation is that when we reach the precipice under present policies there will be a change of policy (e.g., further fall in interest rates or QE) to avert it.” Wendy Carlin (UCL) pointed to “anchored inflation expectations” and Patrick Minford (Cardiff University) highlighted the role of “inflation targets… hav(ing) enormous credibility and lead(ing) to a considerable stabilis(ation) of actual inflation around… targets.”  

Potential spillovers to the UK recovery

Deflation is generally thought to be pernicious because it raises real debt burdens and makes it more difficult for policy-makers to achieve a level of real interest rates low enough to stabilise the economy. This may lead to self-fulfilling negative inflation and output dynamics. Deflation in the Eurozone, which as a region constitutes the UK’s major trading partner, is likely to transmit a contractionary impulse to the UK economy through its impact on confidence, net exports and the vulnerable financial sector. This impact may be great enough to halt the recovery, which has seen output nearly return to its level at the previous cyclical peak in 2008 Q1.[3]

Survey results on the impact on the UK’s economic recovery

The survey produced a clearer consensus that should a Eurozone deflation occur, it would pose a considerable risk to the UK economy: 64% of respondents in both the simple and weighted version of the survey agreed with the question and not one respondent strongly disagreed.

The risk to the recovery depends first on how strong it actually is. There was some disagreement here with Wouter Den Haan (LSE) suggesting that “the UK recovery is still fragile”, whereas Nick Oulton (LSE) felt that “indications for the UK are currently so strong that I would not expect low inflation in the Eurozone to derail the UK recovery” and Simon Wren-Lewis (University of Oxford) “doubt(ing) that weak Eurozone growth would be enough on its own to halt the UK recovery.”  

The possible responses to a Eurozone deflation by the ECB may not be sufficient to pose a risk to the recovery. David Smith (Sunday Times) felt that although a Eurozone deflation “could boost sterling against the euro. Given that sterling is undervalued against the euro, I do not think this would pose a huge risk for the UK recovery. The bigger risk would be if deflation triggered more general eurozone uncertainties.”

In a similar vein, Martin Ellison (University of Oxford) felt that “the flexibility of an independent exchange rate for the GBP may give some hope that policy options could mitigate the effects of disinflation in the euro area, but possible balance sheet effects of non-GBP denominated debts would be worrisome.” 

A number of respondents stressed the vulnerabilities of financial balance sheets. Tony Yates (University of Bristol) argued that a “it may also mean a period of renewed heightened uncertainty about the ability of the ECB to hold the EZ together, and about the health of the EZ sovereigns and banking system. The latter could easily spark a renewed rise in spreads in UK risky assets.” Chris Martin (University of Bath) felt that a there was risk of a “falling asset values and rising levels of real debt that will hit the balance sheets of financial institutions. This may well spill over into increasing risk premia and a more general reluctance to lend in the UK.”

[1] http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-30042014-CP/EN/2-30042014-CP-EN.PDF

[2] Specifically, the five-year forward break-even inflation rate five years ahead and the five-year forward inflation-linked swap rate five years ahead, see Chart 14 on page 33 of the ECB’s April 2014 Monthly Bulletin (http://www.ecb.europa.eu/pub/pdf/mobu/mb201404en.pdf). [The source given in the latter part of this sentence was not in the background information given to the experts and has been added after the survey was closed.]

[3] On 29 April, the ONS estimated that in 2014 Q1 the UK economy was only some 0.6% below the previous peak in 2008 Q1.

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How the experts responded

Euro Area Deflation

Participant Answer Confidence level Comment
David Cobham Heriot Watt University Strongly Agree Very confident
Wendy Carlin University College London Disagree Confident
Although I don't believe deflation is likely, the evidence of anchored inflation expectations supports the loosening of monetary policy by the ECB to boost growth in the Euro Area. Sustained very low inflation not only deflation is likely to depress growth expectations and growth.
Jagjit Chadha National Institute of Economic and Social Research Agree Confident
Vicky Pryce Centre for Economics and Business Research (CEBR) Disagree Confident
There are downward pressures on prices in some countries and there may well be a quarter where we see deflation across the Eurozone but in my view it is unlikely that this will be sustained as the ECB will intervene more aggressively- not only with negative interest rates but also eventually with its own version of QE or any other type of monetary expansion to ensure that this gets reversed. Also there are signs of recovery, albeit rather anemic in a number of countries. and that should help wages recover somewhat. Main worry though remains the possible tightening of bank lending following this year's ECB stress tests which could stifle growth and put increased downward pressure on prices .
Jonathan Portes KIng's College, London Agree Not confident
Although in some models deflation is a threshold: that is -0.1% inflation has a very different impact on other macro variables than 0.1% - I think that in practice this is highly implausible. In my view inflation from 0 to 0.5% is not that different from deflation in its impact and consequences, and we are already there. So while I do not think the probability of negative inflation is much above 25%, nor am I confident in my CPI forecast, I think for practical purposes we are already there, or almost.
Patrick Minford Cardiff Business School Disagree Confident
Sustained deflation is highly unlikely because of the robustness of inflation expectations. We have learnt from wide experience of western countries with accepted inflation targets that these have enormous credibility and lead to a considerable stabilising of actual inflation around these targets. This was tested recently by the Bank of England's decision to let inflation in the UK diverge for a few years markedly upwards from the target. In the euro-zone the ECB has a widely understood and accepted target and has suggested that it would take unspecified measures to ensure that the target is hit in the medium term. These measures could include Quantitative Easing as in the US and UK; but other easing measures are available including paying lower or even negative interest on bank balances.
Luis Garicano London School of Economics Agree Confident
We have had several consequtive months in which price growth has surprised on the downside in the Euro zone. We may be at risk of a self fulfilling dynamic of price drops. Policy makers need to pay maximum attention to this issue given the still extremely high debt levels in many countries, particularly in the periphery.
Martin Ellison University of Oxford Agree Confident
A prolonged period of low inflation in the euro area suggests that the risk of deflation is real. Against this is that long-run inflation expectations (as measured by the survey of professional forecasters) have held up well, although confidence in professional forecasters is not necessarily at an all-time high.
Paul De Grauwe London School of Economics Disagree Confident
Wouter Den Haan London School of Economics Agree Confident
Although there are some signs of recovery in the Euro Area the recovery is weak and structural problems remain. Therefore, we cannot disregard the possibility that the Euro Area will go through a sustained period of low or no growth similar to Japan's experience.
Angus Armstrong National Institute of Economic and Social Research Agree Confident
In NIESR's latest quarterly forecast (published last week) we have euro area inflation of 0.1% to 0.2% in the third and fourth quarters of this year as a central case. Deflation, as defined, would certainly fall within a 25% probability around this central case. The critical question would then become what happens to expectations, which in some part depends on the ECB. NIESR's forecast has inflation back over 1% in 2015 as a central case.
Andrew Mountford Royal Holloway Strongly Disagree Confident
Sustained deflationary episodes are rare and have occurred when monetary authorities have maintained a tight monetary policy during adverse economic conditions. Since the ECB is signalling strongly that it will pursue a loose monetary policy -see e.g. ECB press conference this week (08/05/14) - I think sustained deflation in Europe is unlikely but of course one cannot completely rule out a deflationary blip for a quarter or two.
Paolo Surico London Business School Disagree Confident
Sir Christopher... London School of Economics Agree Not confident
If the ECB continues with its current policies there will be a significant risk of sustained deflation. But recent talk from the ECB indicates that they are aware of the risks. A change of ECB policy can surely avert deflation so my expectation is that when we reach the precipice under present policies there will be a change of policy (e.g., further fall in interest rates or QE) to avert it
Alan Sutherland University of St. Andrews Agree Confident
Christopher Martin University of Bath Agree Confident
I expect mild deflation in the Eurozone over the next year or so. Eurozone inflation has fallen more-or-less continuously since early 2012 and has been below 1% for the past 6 months, All the main components of the price index are growing at less than 1%, with service sector inflation of just 0.1% at the end of 2013. Prices are falling in most periphery countries, including Spain, and inflation does not exceed 1% in any member country. Wages are if anything, rising more slowly than prices. Even a mild continuation of thee trends implies deflation. The only indicator suggesting otherwise is unit labour costs, which have risen slightly. But I expect deflation to be mild, for two reasons. First, I expect the forces that act against deflation, especially resistance of workers to falling nominal wages, to be stronger in the Eurozone than elsewhere. Second, I expect a strong (for them) response from the ECB, probably through a form of QE, which will at first offset and then reverse deflation. Evidence from the US and UK suggests that QE can be an effective remedy for deflation.
Jan Eeckhout University College London Strongly Disagree Confident
Costas Milas University of Liverpool Disagree Confident
Marco Bassetto University College London Strongly Disagree Very confident
I am defining "sustained deflation" as four quarters of negative core CPI (year over year), which is a tougher standard than the suggested guidelines. Total CPI could more easily slip into negative territory, but this could actually be good if it were caused by low energy prices due to favorable geopolitical circumstances.
Francesco Caselli London School of Economics Agree Confident
Tim Besley London School of Economics Disagree Not confident
Ethan Ilzetzki London School of Economics Disagree Not confident
Richard Portes London Business School and CEPR Agree Very confident
HICP inflation falling since late 2011, below 1% since October 2013; core higher but also falling since autumn 2013. Not clear what is your source for '5-year forward inflation-linked swap rate' - I believe the 5-year OIS rate this morning was 0.595%, while the 2-year is 0.18%. Not much between that and deflation! 5 countries of the 18 are already in deflation, and the average for the others is <1%. Survey and market expectations are clearly 'de-anchored' from the ECB 2% target, and so are mine. But this is assuming unchanged ECB policies. The question is how soon and how much they will change.
Michael Wickens Cardiff Business School & University of York Agree Confident
Although activity in the eurozone is picking up, it is doing so slowly and is still a drag on UK export growth
Simon Wren-Lewis University of Oxford Disagree Confident
Although I would not put the risk of deflation that high, this is irrelevant to policy in the Eurozone. Inflation at -0.1 is only slightly worse than inflation of +0.1% - there is nothing magic about negative inflation. What is clear is that inflation is too low in the Eurozone, and that recovery is too weak, so both monetary and fiscal policy need to change.
Nicholas Oulton London School of Economics Disagree Not confident
There may be a significant risk of inflation at a bit below 1% in the euro area for the next year. This would make the real rate of interest actually paid by firms higher than desirable and so impede the euro area recovery. The inflation/deflation dichotomy is not the real issue though obviously if deflation were to occur this would make real interest rates even higher.
Kate Barker British Coal Staff Superannuation Scheme Disagree Confident
Sustained deflation defined as falling prices for a year with price level down 1%. Don't think this very likely.
Silvana Tenreyro London School of Economics Disagree Confident

Spillovers to the UK recovery

Participant Answer Confidence level Comment
David Cobham Heriot Watt University Agree Confident
Fabien Postel-Vinay University College London Agree Confident
Wendy Carlin University College London Agree Confident
A balanced recovery in the UK depends on the growth of net exports and therefore on growth in the Euro Area.
Jagjit Chadha National Institute of Economic and Social Research Agree Confident
David Smith Sunday Times Disagree Confident
Deflation could provoke the ECB into a further monetary stimulus, which could boost sterling against the euro. Given that sterling is undervalued against the euro, I do not think this would pose a huge risk for the UK recovery. The bigger risk would be if deflation triggered more general eurozone uncertainties.
Vicky Pryce Centre for Economics and Business Research (CEBR) Agree Confident
I don't think we will see sustained deflation but if we did it clearly would have an impact on the UK economy to the extent that exports from the UK to the Eurozone would suffer. But in fact our recovery has been based mainly on domestic spending and household consumption and housing construction with private investment beginning to pick up and much less on net trade which has hardly contributed to growth so impact not likely to be felt immediately but deflation in Europe would make a substantial difference if it carried on for any length of time .
Jonathan Portes KIng's College, London Disagree Confident
The direct impact of continued economic stagnation in the eurozone will clearly be negative, but no more so than over the past 3 years, and despite that recovery is now established. If deflation led in turn to serious economic and political instability in the eurozone, that might be different, but that seems unlikely (albeit not impossible) in the short term.
Patrick Minford Cardiff Business School Disagree Confident
If the euro-zone were to experience deflation the Japanese experience suggests that this becomes embedded in the economy in the form of very low long term interest rates and a high demand for money, together with an appreciating exchange rate. Low growth in Japan has its origin in a weak 'supply side'. Having exited from a long period of fast growth in manufacturing, Japan has found it difficult to liberalise its service and agricultural sectors. 'Deflation' has been blamed for Japan's low growth but the evidence for this is hard to find; the evidence of low productivity growth is plain however. If the euro-zone entered deflation I would expect similar behaviour to Japan (interest rates would be low, the exchange rate strong); but low growth in the zone would only occur if systematically low productivity growth policies were adopted. This would be a worrying prospect; but it is a separate issue from deflation. It is often forgotten that under long periods during the gold standard growth was robust.
Luis Garicano London School of Economics Strongly Agree Very confident
John VanReenen London School of Economics Strongly Agree Extremely confident
Martin Ellison University of Oxford Agree Confident
If the deflation in the euro area reflects more general global economic malaise then it is difficult to believe there would be no negative effects on the UK economy. The flexibility of an independent exchange rate for the GBP may give some hope that policy options could mitigate the effects of disinflation in the euro area, but possible balance sheet effects of non-GBP denominated debts would be worrisome.
Tony Yates University of Birmingham Agree Confident
Sustained deflation would probably be associated with a protracted period of weak demand, and therefore weak demand for UK exports. It may also mean a period of renewed heightened uncertainty about the ability of the ECB to hold the EZ together, and about the health of the EZ sovereigns and banking system. The latter could easily spark a renewed rise in spreads in UK risky assets, with all the consequences that that had last time for the UK economy returning again.
Paul De Grauwe London School of Economics Disagree Confident
Wouter Den Haan London School of Economics Agree Confident
The UK recovery is still fragile. Therefore, a weak Euro Area could very well pose a considerable risk to the UK recovery.
Angus Armstrong National Institute of Economic and Social Research Disagree Confident
Moderate deflation over perhaps two or three quarters in the euro zone would be a 'headwind' for the UK through usual channels. However, banks are much less exposed to troubled countries and credit and labour market conditions have improved to the extent that I would not expect the UK to fall beck into recession as a direct consequence.
Andrew Mountford Royal Holloway Strongly Agree Extremely confident
This question almost answers itself. If there is a sustained deflationary episode in Europe then this would be associated with low levels of demand and so would certainly affect UK exports and UK growth negatively.
Paolo Surico London Business School Strongly Agree Very confident
Sir Christopher... London School of Economics Agree Very confident
The UK depends on Europe and anything negative in Europe indicates a significant risk to the UK economy
Alan Sutherland University of St. Andrews Agree Confident
Christopher Martin University of Bath Agree Not confident
Deflation in the Eurozone would affect the UK in two main ways. The depressed level of demand that caused deflation would clearly have an adverse impact on aggregate demand in the UK. And deflation implies falling asset values and rising levels of real debt that will hit the balance sheets of financial institutions. This may well spill over into increasing risk premia and a more general reluctance to lend in the UK. It is difficult to assess the severity of the risk. By itself, it would not be enough to push a robust recovery off track. But if the UK recovery reflects excessive borrowing by over-extended households, the impact of Eurozone deflation on financial markets may be more serious. Until I see evidence of a strong and sustained increase in investment by the ever-reluctant UK corporate sector, I lean towards the latter view.
Jan Eeckhout University College London Disagree Very confident
Costas Milas University of Liverpool Disagree Confident
In my view, the main international factor driving UK growth remains US growth. The Survey of Professional Forecasters predicts, for the US, GDP growth of 2.8% in 2014 and 3.1% in 2015, whereas headline CPI inflation is predicted to be between 1.8% and 2% in 2014-2015. In this context, I remain confident of a positive impact from the international factor on the UK economy.
Marco Bassetto University College London Neither agree nor disagree Extremely confident
Here too the devil is in the details. A couple of quarters of negative total CPI in the Eurozone will not do much to the UK economy. A prolonged period of deflation, or a sharp bout (say, below -2%, -3% Core), would have serious implications for highly indebted countries and firms, with severe adverse economic effects in the Eurozone that would be felt in the UK.
Francesco Caselli London School of Economics Agree Confident
Morten Ravn University College London Neither agree nor disagree Confident
As stated above, deflation as such may not be the real problem (but will make the problem worse due to nominal debt contracts). Should europe's problems worsen, it is likely to impact on the UK because of the close trade and financial links.
Tim Besley London School of Economics Strongly Agree Confident
Ethan Ilzetzki London School of Economics Disagree Confident
Richard Portes London Business School and CEPR Agree Confident
The main short-term effect would be through financial markets and confidence rather than through trade. But if deflation took hold in the euro area as it did in Japan, then there would be a longer-term effect through trade. Neither would in itself take the UK into recession, but either could reduce growth significantly.
Michael Wickens Cardiff Business School & University of York Disagree Very confident
The likelihood of negative eurozone growth is small and so poses no significant risk to the UK economy
Nicholas Oulton London School of Economics Disagree Confident
Given my answer to the first question, there must be some risk to the UK recovery. But the other indications for the UK are currently so strong that I would not expect low inflation in the eurozone to derail the UK recovery. If actual deflation occurred in the eurozone then this would present more of a risk. In my view, a bigger risk at the moment is of a EU-wide recession induced by a sanctions war with Russia over Ukraine. Serious disruption of gas supplies to Europe would have big knock-on effects in the UK.
Simon Wren-Lewis University of Oxford Agree Confident
Weak growth in the Eurozone is not helpful to anyone. However I doubt that weak Eurozone growth would be enough on its own to halt the UK recovery.
Silvana Tenreyro London School of Economics Agree Confident
Deflation in the Euro area would certainly pose a risk to the UK economy, but I don't think *sustained* deflation in the Euro area is likely to occur---unless the ECB takes an unreasonable stance.
Kate Barker British Coal Staff Superannuation Scheme Agree Confident