Europe falls further into the deflation trap

The European Central Bank is taking a wait-and-see approach to its June policy measures but continuing deflationary pressures suggest it will have more work to do to boost recovery.

The eurozone slides ever closer to deflation but don’t expect any additional action from the European Central Bank when it meets in August. The bank took a fresh approach to policy in June but it will take some time to determine whether its moves gain some traction across the financial sector and the broader economy.

According to advance estimates, annual inflation in the eurozone fell to 0.4 per cent in July, to be at its lowest level since October 2009. Inflation remains critically below the ECB’s target for annual inflation of around 2 per cent.

The core measure -- which removes volatile items such as food, energy, alcohol and tobacco -- rose by just 0.8 per cent over the year to July. Deflation is not an immediate concern but it inches ever closer and may prove increasingly problematic for the ECB and the eurozone.

The outlook for inflation remains benign despite the ECB’s new measures, which are designed to foster greater lending towards the business sector. To understand why, we only need to consider the two driving forces of ongoing and temporary inflation: wage growth and the exchange rate.

Wage pressures are driven by greater demand for labour than there is an available supply of workers. When the unemployment rate is low, firms compete for the best available candidates and that results in rising wage expectations.

But with an unemployment rate of 11.5 per cent in June there remains insufficient demand for labour throughout the eurozone. The unemployment rate has improved by just 0.5 percentage points over the past year and it could take longer than five years before the labour market returns to pre-crisis levels.

It is worth remembering that these data ignore the millions of Europeans who have given up on finding a job after years of unemployment, and the millions more who are desperate to work additional hours. In that context, it really is amazing that the eurozone hasn’t been in a deflationary spiral for a number of years.

Youth unemployment continues to be a problem and is tracking much higher than total unemployment across the broader eurozone economy. Youth unemployment was around 23 per cent during June, but much higher in the likes of Greece (around 56 per cent), Spain (53.5 per cent) and Italy (almost 44 per cent).

A depreciation of the euro -- it could be driven lower via quantitative easing or improving prospects among major trading partners -- is also unlikely to contribute materially to inflation since such a high share of euro trade occurs among euro members. Their exposure to other currencies is relatively unimportant compared with other advanced economies.

Geopolitical risk remains the most likely source of near-term inflation but if that eventuates -- and pushes the oil price higher -- then the tentative euro recovery would head towards its third recession since the beginning of the global financial crisis.

That remains an outside possibility but the more pressing issue is improving competitiveness among the periphery, both internally (against other eurozone countries) and externally. A depreciation in the euro would obviously boost the latter and help to support exports; unfortunately, almost every other developed country -- including Australia -- desperately wants its currency to fall.

That leaves internal devaluation -- where a country becomes more competitive via relatively lower inflation -- as the primary option to improve competitiveness and boost activity. This is proving problematic in a currency zone where Germany is stringently anti-inflation and has led to declining wages throughout the periphery. Some gains are being made on the competitiveness front but it has proved a slow and painful process.

The ECB will take a wait-and-see approach to policy over the remainder of the year. It needs to determine whether the actions it made in June will gain some traction and encourage more lending to businesses.

If that eventuates then activity and employment could pick up a little and the recovery might finally gain some momentum. But for now the recovery remains in its infancy and with deflationary pressures lingering, combined with ever-rising government debt, I expect that the ECB will need to do a lot more before the recovery gains firmer footing.