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Factors behind deflationary risk

This article is part of
EU Economy - May 2014

Markets have been holding out for a response from the European Central Bank (ECB) on whether it will take action to snub out any deflationary risk.

At its meeting in May, ECB president Mario Draghi indicated for the first time that it would act to counter low levels of inflation as soon as June. However, the benchmark interest rate was held at 0.25 per cent.

Andrew Humphries, communications director at St James’s Place Wealth Management, says: “Acknowledging the market dissatisfaction with the low level of inflation, Mr Draghi said the central bank was ‘comfortable’ about action next month. Analysts believe that a move by the ECB to cut the cost of money in the region further next month would make eurozone assets look even more attractive.”

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It is a move that many investors believe cannot come too soon. Hetal Mehta, senior European economist at Legal & General, believes the ECB should have been more decisive and points out that the GDP growth figures and inflation data ahead of the June meeting will be “decisive factors”.

GDP numbers released on May 15 were largely considered disappointing. The GDP growth rate of 0.2 per cent in the eurozone for the first three months of 2014 was unchanged from the previous quarter. Economists had predicted stronger growth for the period and while Germany and Spain posted growth of 0.8 per cent and 0.4 per cent respectively, flat growth in France and a contraction of 0.1 per cent in Italy appears to have held the region back.

Ms Mehta notes: “Given the low inflation numbers, it’s been obvious to us for more than a year that we would be stuck in a very low inflationary period in Europe for quite some time without any action. [Taking action] would help the adjustment that the periphery has to make.”

William Hobbs, head of equity strategy EMEA at Barclays Wealth and Investment Management, acknowledges it was not long ago that global investors were warning of hyperinflation.

“Soaring prices were supposed to be an unavoidable by-product of aggressive central bank balance sheet expansion,” he says. “Nowadays deflation is the more topical threat, in spite of still expanding central bank largesse in much of the developed world.”

In a Barclays ‘In Focus’ report, he explains that the forces that push or pull aggregate prices up and down are fluid and claims measurement is “more often art than science” but that the determinants of where prices move can be grouped into ‘demand pull’ and ‘cost push’.

Mr Hobbs continues: “The former is more commonly characterised as ‘too much money chasing too few goods’ and can arise from excess liquidity – if central bank quantitative easing had leaked more visibly into the high street through demand for credit, for example.

“A fuller employment picture could have similar side effects. On the other side, ‘cost push’ inflation tends to arise from supply shortages, of labour or commodity prices.”