How Europe is incubating an even bigger debt crisis by letting deflation take root

Source: Ambrose Evans-Pritchard

The European Central Bank has let it happen. Inflation has been running at an annual rate of minus 1.5% in the eurozone over the past five months, adjusted for austerity taxes.

Funding costs for eurozone countries haven’t been this cheap in years, but an economist Desjardins is cautioning the party might not last. Read on

Prices have been falling at a rate of 5.6% in Italy, 4.7% in Spain, 4% in Portugal and 2% in Holland since September. The rise of the euro against the dollar, yen, yuan and real, accounts for some of this. The eurozone’s trade-weighted index has risen 6% in a year.
But that is the direct consequence of the ECB’s own monetary policy. Frankfurt could force down the euro at any time by switching gears. It has chosen not to do so, hoping that a few dovish words spoken without conviction will turn the global tide.
It is hard to judge at what point deflation becomes embedded in the system. Factory gate prices have been slipping since mid-2012. The pace quickened to minus 1.7% in February, the steepest decline since the Lehman crisis. But this time it is not the one-off effect of a financial crash. It is chronic and insidious.
Prof Luis Garicano from the London School of Economics said the economic models used to predict inflation seem to be breaking down. “They need to take very serious action,” he said.
Bank of America says its “inflation surprise” index keeps ratcheting lower as one shock after another hits, while its gauge of “deflation vulnerability” has been flashing red for most EMU countries. The effect is deeply corrosive, even if the region never reaches technical deflation.

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