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Deflation Danger 130705

Deflation Danger 130705

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Published by: eliforu on Jul 07, 2013
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Deation Danger
INSIDE:Market overview:
Taper tattle
Abenomics -Japan’s agendafor change
UK orecast:
Holiday season
In this edition o Fundamentals, LGIMeconomist Hetal Mehta examines theoutlook or euro area ination andthe implications or economic policy.Any urther negative shocks threatento push the euro area into deation,prompting ears o a Japanese-stylelost decade, which could re-ignitethe debate on debt sustainability orhighly indebted countries.
Driving this disination are two broad
categories: structural and short-term.
The structural causes are concerned with
underlying trends and fundamental economicissues facing the economy and are closely
related to core ination, while the short-term
causes generally relate to movements in morevolatile components such as energy and food
prices which feed into headline ination.
Although the ECB targets the headline rate of 
ination, this is largely driven by movementsin core ination. So why is core ination set tofall? Over the long term, core ination movesin line with unit labour costs, i.e. wages perunit of output per worker
(Figure 1)
, and in theeuro area, these have broadly stabilised, so
Euro area consumer price ination hasbeen on a downward trend since mid-2011.And aside from any near-term volatility, webelieve that this trend is likely to continuewell into 2014 before stabilising at a ratefar below the ECB’s target of “close to butbelow 2%.”
The euro area is heading for a period of dangerously low inflation butthe European Central Bank in unlikely to respond aggressively tocounteract this.
no longer add upward pressure tocore ination. This has come about
as a number of periphery countries
embark on an internal devaluation- a downward adjustment of 
domestic production costs
(Figure 2).
This process is a key partof the post-crisis growthstrategy, especially forperiphery economies, to regaincompetitiveness, rebalance and
gradually return to a model of 
sustainable growth. One elementof this is the moderation in wagegrowth particularly in Spain, wherewage indexation has largely been
removed. In many countries publicsector pay has been severely
cut back, which has also had aknock-on impact on the privatesector where wage growth is now
more subdued. Also helping toreduce unit labour costs is the
improvement in productivity,
although so far this is largely dueto the sharp falls in employmentthan rising GDP. But the labour
market is a lagging indicator, soeven as the economy stabilises,employment is likely to continueto fall, thus helping to increaseproductivity and lower unit labour
(Figure 3).
Unemployment is also a related
driver of core ination. Europe’s
sharp increase in unemployment
from 7.3% at the start of 2008to over 12% currently has
reduced the amount of demand
in the economy, meaning rms’pricing power remains veryconstrained, which is puttingdownward pressure on prices.
LGIM forecasts euro areaunemployment to continue rising
until it peaks at 13% in early2014
(Figure 4),
so we believe
the negative impact of higherunemployment is set to continue.The ongoing structural reforms
to liberalise product markets arealso likely to generate greater
price competitiveness and hence
downward pressure on pricing.The exchange rate is the nalreason why we believe coreination is set to continue onits downward trend. From thesummer of 2011, when theeuro crisis intensied, up until
ECB President Mario Draghi’s
‘whatever it takes’ speech and the
announcement of the OutrightMonetary Transactions policy
in summer 2012, the euro wassteadily depreciating, but since
then the euro has appreciated
by 8% on a trade weighted basis.
This in turn has helped to reduce
import prices, increasing thedownward pressure on ination.
Bringing all these factors together
(and assuming the exchange ratemoves sideways) we forecastthat core ination in the euro areawill average just 0.4% in 2014.
While the underlying trend in
core ination may be downwards,what about headline inationwhich the ECB targets? Thistends to track above core ination
as the price of volatile items suchas energy and food generallyincrease at a faster pace thanother prices.
Source: Reuters, EcoWinFigure 1. Core ination moves with unit labour costs over time
Core CPI inflation, %Y/YUnit labour costs, 3Y change, %
Source: Reuters, EcoWin, LGIM estimatesFigure 2. Unit labour costs by country
901001101201301402000 2002 2004 2006 2008 2010 2012 2014
   I  n   d  e  x ,   2   0   0   0   Q   1  =   1   0   0
Germany France Italy Spain Euro areaForecast
Unit labour costs and core CPI ination
Whole economy unit labour costs
But even on this front, thereare downward pressures. Backin April of this year, euro areaheadline ination fell quitesharply, and largely unexpectedly,to 1.2% in year-on-year terms.
While some of this surprise fall
was due to temporary factors(and as anticipated there was abounceback in May to 1.4% yoy),this downside surprise is likely
to have played a part in the ECB
cutting interest rates by 25bpsto 0.50% in May. And lower oilprices, which are down over 10%
in euro terms
(Figure 5)
since the
start of this year, are only now
starting to feed through into
energy prices. Our projections of euro area energy price inationof 3% factors in oil prices movingsideways until the end of 2013before increasing $1 per quarterthrough 2014.Other short-term factors willalso play a role in pushing downination. Both Spain and the
Netherlands increased their
VAT rates to 21% last year,representing increases of 3% and2% respectively. These increases
pushed up euro area headline
ination by around 0.2% at the endof 2012, and so can be expected
to shave off a broadly similar
amount in the autumn when the
increases fall out of the year-on-year calculations.
But after these base effects wearoff, we forecast that headlineination will remain subdued andbroadly steady, averaging just1% in 2014, compared with theECB’s forecast of 1.3%
. Despite all of the above
reasons for expecting inationto fall substantially below theECB’s target, we believe outrightdeation in the euro as a whole isunlikely.
Even if deation was tomaterialise, short-term deation
is usually not particularlyharmful as it boosts purchasing
power. However, a period of sustained deation, such asJapan’s experience, can become
an entrenched vicious circle
that may be hard to break. Thenegative impact of deation,or even low ination, will mostacutely be felt by countries with
high debt levels. Without the
ability to inate away the realvalue of debt, governments will
come under pressure to proceed
with both aggressive austerity
plans to reduce the level of debtalongside further structural
reforms to boost GDP, potentially
leading to further economic
weakness and a deationaryspiral, renewing market fears
regarding debt sustainability.
But even for periphery countries,higher ination is no panacea.Being able to inate away debt
comes at the cost of losing
competitiveness, particularly in axed exchange rate regime where
a devaluation of the currency isnot possible.
Source: Reuters, EcoWin, LGIM estimatesFigure 4. Euro area unemployment rate
6101418222630342000 2002 2004 2006 2008 2010 2012 2014
Spain (LHS) Germany France Italy Euro area
Source: Reuters, EcoWin, LGIM estimatesFigure 3. Contributions to euro area unit labour cost growth
-6.0-4.0- 2006 2007 2008 2009 2010 2011 2012 2013 2014
Wages Employment GDP* ULCsForecast
Contributions to y/y unit labour cost growth
Unemployment rate
*Positive GDP growth contributes negatively to unit labour costs

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