For months we have been treating deflation as though we are tracking a storm on a weather map heading our way. But that may well be the wrong image. Deflation may already be here.
Consider the evidence. Germany’s federal statistics office said last week that real wages - after inflation - fell in 2013. This was unexpected because other surveys suggested they had gone up. What seems to have happened is profit-related pay and other hard-to-measure components of wages came down last year.
For the eurozone, German deflation is a nightmare. If the periphery wants to become more competitive, it needs lower inflation than Germany. But if Germany, too, is deflating, then either the competitive adjustment will not happen; or the whole of the eurozone goes into deflation; or, more likely, both.
Insee, the French statistics office, announced that the annual rate of core inflation - without volatile items and tax measures - dropped sharply from 0.6 per cent in December to 0.1 per cent in January. Factory prices are another forward-looking indicator. According to data from Eurostat, the EU’s statistical office, they went down in the eurozone as a whole by a whopping 0.8 per cent annually in December.
Does the European Central Bank not see this? Of course it does. But its analytical framework tells it to remain relaxed. Its highly sophistical economic model sees only marginal risks of outright deflation in the official consumer price index.
The ECB also analyses monetary flows. That analysis, too, suggests there is little to worry about. The fall in broad money supply, according to the ECB’s latest monthly bulletin, has technical causes. The bank believes this is most likely not a sign of deflation.
There are good reasons to doubt this optimistic interpretation. For a start, the economic model did not predict the current decline in reported inflation rates. This is not surprising. One of the shortcomings of these models is that they cannot easily grasp financial shocks because these models have no finance in them. They are better suited to deal with an alien attack than a credit crunch.
The ECB is also clinging to the straw that consumers still expect a sustained rise in prices. There are various technical financial market indicators that measure current expectations of future inflation, each with their own merits and faults. These indicators contain some information but the problem with all of them is that they are estimates based on market prices - and they can change faster than central banks can change policy.
Remember what happened in Japan? Once its economy settled to a new steady state with negative inflation and zero growth rates during the 1990s, it got stuck in a hole. There is still a dispute over whether fiscal or monetary policy is the more suitable instrument in such a situation. But there is no dispute that a policy mixture of fiscal rigour, excessive monetary tightness and a refusal to deal with the zombie banks is not going to work. The ECB always says Europe is not Japan. Indeed, it is not. Europe’s position is potentially worse.
One problem for the ECB is that it is the central bank of a monetary union. It has no government as a direct counterpart. Unconventional policies, such as quantitative easing, are therefore more complicated, technically and legally. But like all technical questions, these are ultimately soluble. The ECB has more or less exhausted its room for conventional policies. Its two most relevant interest rates stand at 0 and 0.25 per cent respectively.
The only tools strong enough to stem deflation are unconventional. These could include purchases of sovereign and corporate bonds, bank bonds or even company shares. They could also include funding-for-lending schemes, support for small company loan securitisations or, in extremis, direct lending to companies. But the longer one waits and the longer deflation festers - the more it affects wage settlements and prices for goods and services - the harder and more costly it will be to get rid of.
With so many signs of deflationary pressures, the case for unconventional policies is overwhelming. Then again, it has been overwhelming for a while.
Copyright The Financial Times Limited 2014