Good Deflation better than Bad Inflation

Central banks seem to be keen on avoiding deflation at any costs but inflation for its own sake is likely to be worse  

Inflation is on the retreat in much of the world giving rise to concerns about deflation.  Economic theory along with the experiences of Japan makes deflation one of the most feared outcomes in economics.  The central bank in Japan is planning to double its money supply as part of its battle to end deflation while the European Central Bank cut interest rates after inflation figures in October were too low for comfort.  The fears about deflation have resulted in policies which suggest that inflation in any form is better than deflation.  But deflation is a symptom of bigger problems and the prescribed cure may do more harm than good.

Economics textbooks paint a grim picture when it comes to deflation – lower prices translate to less money to pay off debts for both businesses and governments with consumers holding off on purchases if today’s prices are likely to be lower tomorrow.  Japan has been a case study of the damage done by deflation –the bursting of a gigantic financial bubble in 1989 resulted in around two decades of falling prices seen as sapping the life out of the Japanese economy while government debt has reached around 230% of GDP.  The years of deflation reinforced the notion of deflation feeding upon itself to reduce demand for goods and services and further drive down prices.

However, according to this rationale, deflation is the cause of the problem rather than simply a sign of a sluggish economy.  The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past.  We can see an example of how this works in that stock prices in Japan are still less than half their peak value, highlighting the extent to which prices can be massively overinflated.  Prices for consumer goods are not subject to the same price pressures as in the stock market but the example illustrates the consequences of economic overheating.

There are parts of Europe with similar issues but nowhere is close to being on the same scale.  So, while Japan shows what can happen, its relevance to Europe is likely to be limited.  The deflation emerging in Europe, such as in Greece and Spain, is the result of weak demand coupled with falling wages which helps businesses by lower their costs.  The lower wages are needed for these countries to regain their competitiveness relative to the rest of Europe as other options, such as currency devaluation, are not available for countries in the Eurozone.

The response of central banks in Japan and Europe has been to use monetary policy to weaken their respective currencies but this targets the symptom and not the problem.  A weaker currency increases the price of imports and is tantamount to paying foreigners more to buy stuff just to create inflation for its own sake.  However, higher prices are more likely to result in consumers tightening their belts as their purchasing power diminishes.  The idea that low inflation requires more of the same approach misses the fact that these monetary policies bring their own costs with little benefit.  Deflation doesn't seem so bad in comparison.

Monetary Policy – via the currency market

With the banking system clogged up, the European Central Bank is looking for other ways to make monetary policy work

Unconventional - this is a term currently used to describe many new elements of monetary policy such as quantitative easing.  It could also be employed in relation to the manner in which monetary policy works nowadays.  The European Central Bank (ECB) cut interest rates in November 2013 due to concerns about deflation (for more info, see previous blog) but the effects are not expected to work through the banking sector as would normally be the case.  Instead, the unspoken target of the policy change was the value of the euro.  This is stuff that you won’t find in any economics textbook, so how does it work and why is the ECB having to rely on such disingenuous tactics for its policies?

The normal result of a cut in interest rates would be a boost to the economy through an increase in lending with lower borrowing costs convincing more households and businesses to take out loans.  The extra spending that this generates would spur on the economy.  But this policy route is not working at the moment as demand for new loans is weak irrespective of how low interest rates are.  The fall in inflation has prompted growing concerns about deflation and the ECB felt the need for further action to signal its intent to prevent this.

Accordingly, the ECB is targeting another avenue (without stating it outright) to achieve the desired results – the currency market.  Europe has been burdened with a currency which reached a two-year high against the US dollar in October.  This is relevant to the fight against deflation in two ways – a stronger currency hurts the economy by making exports more expensive (and harder to sell overseas) as well as reducing the prices of imports (which adds to downward pressure on prices).  A reversal of this trend, that is, a weaker currency, would then work in Europe’s favour and is one of the few levers available to the ECB.

A lower interest rate helps to drag down the value of a currency by reducing the benefits of holding cash in that currency and providing an extra incentive to sell.  This effect is further magnified by the large amount of cash sloshing around in the global financial system at present.   But it is not so easy - some other central banks (namely the Bank of Japan) are keen on achieving the same results through similar policies and not all countries can have weak currencies.  This has resulted in the coining of the term "currency wars" as countries battle to drive down the value of their currencies.  It all sounds rather dramatic but it is evidence of how things in the system of finance are far from normal.

ECB Rate Cut – what's the point?

The European Central Bank set itself apart with looser monetary policy but how is this likely to make any difference to the economy?

Central banks have been busy recently, whether it be talk of forward guidance from the Bank of England or the tapering of bond purchases by the Federal Reserve.  The exception had been the European Central Bank (ECB) which had been going through a quiet period after monetary policy helped to put paid to the Eurozone crisis in 2012.  Worries about deflation jolted the ECB back into action following data showing that inflation was down to 0.7% in October.  The ECB decided to respond last week by cutting its benchmark interest rate from 0.5% to 0.25%.  But, with interest rates already low, will a further reduction make much of a difference to the economy?

A cut to interest rates is something of an anomaly as the ECB is the only major central bank which has not already lowered interest rates as much as possible.  The recent trimming of its key interest rate follows cuts in July 2012 and May 2013 with the ECB using this drip-feeding of interest rate changes to respond to new data on the economy in Europe.  The focus of policy has shifted from saving the Eurozone from collapse, which was achieved by the ECB taking a stand pledging to do “whatever it takes” to save the euro. Instead, the ECB is looking to boost growth with the hope of staving off deflation.

Lower prices may sound like a blessing to consumers but this fall has the effect of making debt tougher to pay back as selling the same amount of goods generates less money for firms which also means that the government misses out on tax revenues.  Not exactly what a heavily indebted Europe needs at the moment.  This is the reason why central banks will typically adjust policy to achieve inflation of around 2% - better to have a small amount of inflation than succumb to deflation.  Inflation has been decreasing elsewhere as well such as in the UK (see previous blog) due to weak growth combined with a fall in global commodity prices (see Inflation – then and now for more on how inflation works).

The interest rate cut in itself will actually have little effect with households and businesses in Europe not keen on borrowing while the economy is so weak.  Rather it is a signal of intent – the ECB will continue to loosen monetary policy while some central banks elsewhere (the US and, to a lesser extent, the UK) are approaching the beginning of the end of their loose monetary policy.  The key mechanism by which this will be fed through into the economy is likely to be the exchange rate but more on this later…

All bets are ON

Both the government in Japan and many investors are betting on the power of monetary policy but it is not much more than a roll of the dice.

Japan has long suffered at the hands of the same problems that have hit Europe, and as a result, the central bank in Japan has also been a pioneer of the loose monetary policy which has since become the mainstream response to such problems.  The recently-elected Japanese government has upped the stakes with a further round of monetary policy which goes far beyond anything previously proposed.  Investors too have been putting their money on the line in the hope that the new measures will bring about a long awaited revival in the Japanese economy.  However, the limited effect of monetary policy so far in the aftermath of the global financial crisis suggests that this is nothing more than a gamble in order to avoid some tougher choices.

A massive financial bubble in Japan in the late 1980s has resulted in two decades of economic stagnation due to the now common culprits of the overpriced real estate market, overwhelming government debt, and a lack of sources of growth.  The interest rates have been set close to zero for more than a decade while the Bank of Japan has also pumped money into the economy.  Successive Japanese governments have held back from making the necessary reforms to help the economy unwind the imbalances built up during the boom years and instead amassed debt equal to 230% of GDP, rather than deal with the problems that the country is facing. 

The new wager on monetary policy involves a doubling of the money supply as part of measures to achieve inflation of around 2% in two years.  However, the new monetary measures will just be another stalling tactic if not combined with other policies which help to kick start business activities.  The immediate effect of printing more money is that the value of the yen has dropped from below Y80 to over Y100 against the US$.  A weaker yen is a boon for many of Japan’s manufacturing giants who have large exporting operations.  The boost to their profits along with hopes for a new beginning for the Japanese economy has prompted many investors to throw in their lot with the Japanese government and the stock market surging by almost 70% in 6 months until a recent setback.

Yet this is symptomatic of actions by governments and investors across the globe.  Booms and busts in any economy involve considerable transformation as businesses adjust to new realities and government can either try to facilitate this process of companies adapting, which helps the economy become more productive over the long term, or stand up against forces of inevitable change to ease the short term pain.  Prior faith in monetary policy has enabled governments to believe that central banks have the power to restart economic growth with less hardship.  But new engines of growth are not given the scope to expand and monetary policy is relied upon more and more to prop up the economy. And using monetary policy to weaken a currency and boost exports will only work as long as the country’s central bank is expanding their money supply faster than anywhere else (for more on this, see Currency Wars).

This complicates the process of selecting investments with a layer of politics being overlapped with normal considerations of business profits and economic performance.  And with monetary policy taking a more dominant role in the strength of the economy, investors find it necessary to track the actions of central banks rather than just corporate activities and economic indicators.  As such, investors are second guessing what the central banks will do while the central banks take their best shot at what they think will be good for the economy. 

It is questionable whether the current set of policies that are commonly employed by central banks have been of much use so it is a considerable punt by the Japanese government to put all its money on more of the same despite any consensus which suggests otherwise.  But it is a way of being seen to be proactive while actually avoiding backing more difficult choices which are more likely to pay off in the long term.  And with bets in the stock market following the government line, this will multiply the losers and add to the woes of those who actually try to sort out the mess in the future.

Walking a Tight Line

Europe is being caught between convincing investors that all is well while trying to stop the improving outlook from feeding through to a strong currency.

All of the fires that had been keeping politicians busy over the past few years seem to have been put out – the Eurozone is no longer on the verge of collapsing, politicians have come up with a short-term comprise to deal with increasing government debt, and the outlook for the global economy looks likely to improve in 2013.  So with disasters averted, the focus is turning to generating growth in stagnating economies.  With domestic markets still sluggish, exports have been targeted as a route back to economic recovery and a weak currency is a crucial advantage.  But what seems easy in theory is tricky in practice.

This shift has been most pronounced in Europe.  The worst seems to be over with investors having been snapping up bonds from previously shunned countries such as Spain and Italy over the past few months.  But the long slog of getting the economies in Europe moving again still lies ahead (refer to Both Good News and Bad News for Europe for more on these two trends).  Exports have been targeted as a source of growth by tapping into perkier demand in emerging markets.  A weaker currency is an easy shortcut into foreign markets but such a policy is of little use (and could work to the determent of all) if other countries follow suit.  Hence, the rise of concerns about “currency wars” as the policy of central banks printing cash to prop up weak economies has also had the added benefit of lowering the value of currencies (for more on this, refer to Currency Wars).  Currencies will tend to fluctuate depending on economic forecasts with weak growth linked to a low interest rate which puts off investors from holding cash in that currency. 

The new government in Japan has been quick to push its central bank into pumping out more cash.  On the other hand, Europe has been hamstrung by fears about inflation from the overly cautious Germans as well as brighter prospects for its economy now that the dark clouds of the Eurozone crisis seem to have passed.  So the improving situations in Europe along with its less aggressive monetary policy could saddle the Eurozone with a strong euro which could scupper the recovery.  The euro had held up reasonably well despite the turmoil as the currency remained necessary for trading with the large single market in Europe.  The perceived turnaround with regard to the fate of the euro has resulted in investors rushing in to buy bonds of Spain, Italy, and the like due to their higher interest rates. 

A further problem is the different competing view on what would be a suitable policy with regard to the euro.  On one side of the argument, the French president Francois Hollande has called for a managed exchange rate with a target for the exchange rate set by the European Central Bank.  France is averse to market reforms which would improve competitiveness so a weaker euro is an easier option.  Jens Weidmann who is the head of the Central Bank in Germany sits at the other end of the spectrum and argues against a weak euro as this will increase inflation (due to imports becoming more expensive).  The Germans have also been among those most vocally critical of the Japanese government influence over its central bank and its aims to reduce the value of the yen. 

Squeezed between the two powers (France and Germany) in Europe is Mario Draghi, the president of the head of the European Central Bank, who takes a more nuanced stance.  It is Draghi who has done the most to stabilize the situation in the Eurozone (see Whatever it takes) and has tried to instil confidence in the fate of Europe while stopping the euro getting stronger as a result.   Draghi came out with a statement earlier this month that it was not the role of the European Central Bank to dictate the value of the euro.  However, strengthening of the euro and any resulting inflation would require action.  This would involve interest rates being nudged up from their current low levels and the growth prospects in Europe would suffer as a result – hence stopping a possible rise in the euro in its tracks.

If Your Neighbourhood Economist was to bet money on the outcome of this tussle, it would bet on Draghi.  The ability of the European Central Bank to act without being restricted by what voters might think gives a reason for investors to listen to what Draghi has to say.  The policy of the European Central Bank to do “whatever it takes” has helped to save the Eurozone despite no action having been taken as yet and this shows how an intention to act by itself can influence the market forces.  It may take more than words and a splash of extra cash to keep Europe on track but the situation could be significantly worse considering the competing opinions in Europe.