By Prakarsh Jain
All say, deflation in the United States is decidedly unlike, but to counter the argument, great ruler, outgoing Federal Reserve Chairman Bernanke remarked, he would be foolish to rule out the said possibility altogether. The remark was made when the annual inflation in the States exceeded 2%, and the jeopardy of it becoming negative was without a doubt remote; but Mr Chairman nonetheless felt it necessary to plan an escape route from a potentially calamitous consequence. The response that he described then was essentially a broadcast of the strategies that were implemented in the aftermath of the 2008.
Correspondingly, the threat for Eurozone is not remote. Annual consumer price inflation is ~ 0.9 per cent and ~ 1 per cent, if energy and food prices are excluded, that is 100 basis point below the Central Banks target of keeping it close to 2 per cent. With the economy operating way below full capacity and unemployment being above 10 per cent, the risk of further decline cannot be omitted (especially given downward pressure from a gradually escalating exchange rate and a global context of negative growth and subdued commodity prices). Therefore, it is time to recognize the deflation danger facing Europe and to consider what could be done to prevent it.
Problems with deflation:
- It tends to raise the real interest rate above the equilibrium level. In addition, as there is a zero lower bound to the nominal interest, central bank would find itself incapable to ride the interest rate or the inflation differential to a low level, which eventually would result in a slump and a downhill spiral.
There have been instances, when some central banks (Denmark in 2012) have charged commercial banks for taking deposits, thereby indicating negative interest rates. Nevertheless, there are limits to such manoeuvres, because if accountholders were charged, at a point it would become preferable to buy safes and store notes.
The noted is highly relevant for Eurozone, which is evolving from a long recession period, with GDP still below the pre-crisis level and the recovery still lacking its full momentum. Having documented the vulnerability, European Central Bank has sunk its benchmark interest rate twice in recent times, to 0.25 per cent. The trick is that this may be too late to move the real interest to where it should be in order to nurture sufficiently strong enough economic recovery.
- It makes economic rebalancing much more painful (especially for the Eurozone). From the month of October 2012 to October 2013, inflation was actually negative in Greece and Ireland, and around zero levels in Spain and Portugal. However, these nations still need to gain competitiveness by dropping the price of their exports, as they need to withstand external surpluses to correct the hoarded imbalances. With inflation in the Eurozone soaring near zero levels, countries face uncomfortable choice between competitiveness and unfathomable domestic deflation.
- Finally yet importantly, deflation intensifies burden of debt. Dissimilar to equity, debt security is a claim whose value does not vary depending on the inflation. On the other hand, with deflation leading to negative income growth, weight of debt relative to income increases, possibly becoming intolerable for borrowers and increasing the risk of sovereign, as well as private debt crises.
There was a clock when this debt deflation scenario was purely a case study in macroeconomics. Situation does not remain the same anymore. As a consequence of deflation and recession, GDP in Greece, Spain, Portugal, and Ireland is at the same level today as it was in 2005. For this reason, and despite all the deleveraging exertions, heirlooms of past failings still weigh heavy on these economies.
European Central Banks recent interest cuts reflect its concern about these risks. Definitely, it expects a lengthy period of low inflation, followed by a slow but sure upward movement, with downside risks to this situation. In view of that, it expects its main policy rate to continue at current 0.25 per cent level.
But then again, while the European Central Bank cannot be accused of deserting the deflation risk, the struggle with its stance is that keeping inflation at ~ 1% and thereon hoping for a deferred and slow but sure ascent is hardly enough. Not only does it run counter to what is planned to be achieved; it correspondingly implies too small a buffer in case of further deflation; leaves too much sand in the wheels of Eurozone rebalancing; and makes deleveraging unnecessarily painful.
The question arises; can the European Central Bank do more?
Having acted boldly to preserve the integrity, it has felt duty-bound not to antagonize policy warmongers and to blunder on the side of caution in formulating the monetary policy. This is an only uncomfortable middle way for the situation.
On the other hand, the European Central Bank could put political precision aside and do more to fulfil its price stability decree by bringing out an approach for normalcy, and thereby indicating an unambiguous readiness to adopt an explicit list of unconventional policies. The point is that the European Central Bank must be prepared to make that choice. As Chairman Bernanke can confirm, conventional monetary policies may stop working quite sooner rather than later.
Prakarsh Jain is a graduate in Commerce from Jai Hind College, post-graduate in Master of Global Business-Investment Banking & Wealth Management from S P Jain School of Global Management and a Chartered Accountant (CA). Currently, Mr. Jain is working with Mizuho Securities, a wholly owned subsidiary of Japanese investment Bank in Corporate Advisory team. From an early age, Prakarsh has been actively involved in various competitions & debates at national/international level and in recent time has represented UAE at the KPMG International Case Competition (KICC 2013) held in Spain. In addition, he has also acted as a delegate at the World Islamic Banking Conference: Asia Summit held in Singapore.