That Dreaded D Word

“Dial D for Deflation” declared the Economist in 2002 in an article which amazingly is still available online. Since Alan Greenspan officially declared the deflation scare over, the word has hardly cropped up in economic debates.

Yet anyone looking at the rapid rise in value of the euro, and the absence of growth in some key economies – Germany, Italy – could have been forgiven for thinking that the ‘all clear’ signal was being given a bit too soon.

Today the latest EU inflation figures are out from Eurostat (PDF file), and Goldman Sachs are warning that: ?without preventive action from the ECB, unit labour costs threaten to pose a future risk of deflation?.

Core inflation in the eurozone, (ie inflation excluding energy and processed food) has – as the FT indicates fallen to its lowest rate in more than four years. The implication of this is that European Central Bank will soon achieve, or even undershoot, its inflation goals.

Excluding volatile energy and unprocessed food costs, prices were rising at an annual rate of just 1.4 per cent in April, this was down from 1.6 per cent in March and is the lowest rate since February 2001.

Headline inflation figure was 2.1 per cent, unchanged from March. It has been as high as 2.5 per cent during the past 12 months.

But behind these numbers lies a much more complex picture, since these numbers are ‘harmonised’: ie they are averages. Several countries already have their inflation rates significantly below the 1.4% figure, and thus must be considered to have ‘downside risks’ of slipping below that magic zero line.

Should this happen, and thinking minds must surely consider both Germany and Italy at risk here, it will be a real policy headache finding a way to drag them out again. Japan, it will be recalled, has been mired in deflation since the mid 90s.

Goldman Sachs calculated that……. if maintained, growth rates for wages and unit labour costs were consistent with consumer price inflation of close to zero per cent. ?If unit labour cost inflation falls any further, it will reach levels that prompted the US Federal Reserve to take preventive action against deflation in 2002 and 2003,? the report said.

At present ECB President Jean-Claude Trichet is still focussed on the problem of inflation, and is ruling out interest rate cuts later in the year. If current disinflation trends continue he may well have cause to change that opinion. Let’s hope he doesn’t leave it too late.

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".