FINANCIAL ICEBERG

Always consider hidden risks

​

MARKET INSIGHT

Europe and Deflation Scare

​( From FRED , Monetary Economics, Reuters, Washington Post, Financial Observer,NowandFutures, Trading Economic, ECB )

If you would like to receive our free daily markets updates, please Sign-up

The Situation



​Central Banks has been extremely aggressive lately on Quantitative Easing (QE) except Europe. With Europe still upon a protracted period of austerity, that continued trend with the world economy slowing increase threat of deflation. The fiscal-tightening in several continental nations is needed to curb ballooning government debt loads that have spooked investors.



But in trying to resolve their fearsome public debt crisis, European leaders may be risking another equally dangerous malady. The new debt-fighting measures will siphon demand from a eurozone economy that was expected to barely grow this year even before concerns over a potential Cyprus default roiled world markets.



Now, some analysts warn that the fiscal discipline could even tip Europe into outright deflation, a potentially destabilizing episode of self-reinforcing price declines that once begun would be enormously difficult to escape. Already in March, consumer prices fell in Greece for the first time since the government began keeping such records in 1969.



​​​



​​



​​



​​







​​

Conclusion



Looking ahead, price developments over the medium term should remain contained in an environment of weak economic activity in the euro area. Inflation expectations are firmly anchored and in line with price stability over the medium to long term. Risks to the outlook for price developments continue to be broadly balanced over the medium term, with upside risks relating to stronger than expected increases in administered prices and indirect taxes, as well as higher oil prices, and downside risks stemming from weaker economic activity.

​​

“Despite muted inflationary pressures and mounting signs that the already weak eurozone economic situation is deteriorating anew, the ECB still looks likely to hold off from cutting interest rates,” said Howard Archer, chief European economist at IHS Global Insight.



​​ The ECB’s forecasts for inflation remain low – with a central expectation for inflation of 1.3% for 2014. The effects of past increases in energy prices and indirect taxes will gradually fall out of the inflation rate over the next 3-6 months, meaning that the headline inflation rate could fall to rates consistent with the ECB’s 2014 forecast. However, we think the risks are that, once any renewed increases in indirect taxes or energy prices are taken into account, euro area inflation could trend even lower. And that’s an issue inasmuch as it’ll be much harder for the ECB to anticipate and project persistently lower inflation without taking policy action.



​​Low and falling rates of core inflation in much of the periphery are, we think, a reflection of their persistent economic weakness. And as such, we think the trend in inflation will persist as well. Indeed, there has been a decline in this measure of underlying inflation in France,

which may also reflect its economic weakness.

​

The only way in order to solve the world’s problems, more supply-side reform is needed rather than further ineffective money printing. And til now, EU strategy has not been on creating demand for goods and services but mainly on austerity measures.

​

The ECB is, however, alert to the weak demand issue in the periphery - those countries where much of the debt crisis has raged and where austerity policies pursued to meet bailout conditions and deficit targets have trimmed any growth potential out of the economy.



This will keep deflation pressure.

​​

Money and Velocity

​

​ The velocity of money is the average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time. Velocity has to do with the amount of economic activity associated with a given money supply.

​

What was surprising since the financial crisis, is that even with huge QE done by the major Central Banks ( Except Europe ), inflation remains tame because the velocity of money tumbles in time of crisis like declining more rapidly in 2009 as shown by the graph below...

​​

“Velocity of money” also matters, not just the “quantity of money”



Inflation is not only linked to the “quantity of money”, but also to other factors that are part of the “quantity theory of money”. This equation is MV=PQ, which includes also the “velocity” of money. Keep in mind, that inflation is a result of money in circulation, not money asleep in saving accounts. As defined below, “velocity” measures the ratio between money in circulation and money in saving accounts.



Since the financial crisis in 2008, this velocity has seriously dropped with money clogging in checking accounts, because consumers are afraid to spend their money and buy products and services from corporations and other businesses.



Thus, the authorities are forced to inject money into the economy to keep business staying afloat.



MV=PQ includes :



M: Money supply. The ECÙB is currently injecting some amounts of money into the economy. Part of this money can circulate, but the rest of it may quickly get stuck in saving accounts. When needed, the ECB will be ready to revert the trend and absorb back massive amounts of money by selling its huge piles of bonds for an attractive yield.



V: Velocity of money. The “velocity” of money is defined as the ratio of money income (i.e. spending by others = wages or income into deposit accounts) to the money stock (sum of all bank accounts, etc.). This definition allows to measure the variations on how fast the hot money circulates – instead of clogging or sleeping in bank accounts – between bank accounts of consumers, shops, corporations and finally of workers.



P: Price level. If the price level varies, then there is deflation or inflation. The price levels are measured by armies of civil servants, who take note of prices in shops or else.



Q: Production level. More Q is the goal, because it means more wealth and more employment to produce this wealth. However, Q doesn’t vary fast, due to delay for hiring and training new workers, and for producing and distributing the new products. It means that if M grows too fast, only P or inflation will follow.



Actual Level of Inflation



Inflation across the 17 European Union countries that use the euro fell for the third month running in March to its lowest level in nearly three years, official figures showed last week.



Eurostat, the EU’s statistics office, said consumer prices in the eurozone were up 1.7 percent in March from the year before, its lowest rate since August 2010 and down from 1.8 percent in February. Weaker energy price inflation was one of the main reasons behind the fall.

​

Though the decline takes inflation further below the European Central Bank’s target of keeping price rises just below 2 percent, no change in interest rates is expected at Thursday’s monthly policy meeting.



The decline in inflation in March was widely expected, though some economists were anticipating a bigger drop to 1.6 percent, as prices continue to be weighed down by the recession and high unemployment, which, among other things, keeps a lid on wages and consumer spending.



​​

So on the chart below, we can see that the growth of the money aggregates M3 ( defined as Currency plus demand deposits. plus other checkable deposits. plus repos, money market funds, savings, and time deposits plus other liquid assets ) is growing even if inflation is falling. Velocity is part of the answer...



The Deflation Scare



​​ The weakness in global trade could result in a new deflation scare before the end of 2013, according to a leading economist.



Andrew Hunt said he expected a deflation scare unless global consumption rebounded.



“Towards the end of the year, if the real economies haven’t picked up, we could well see another deflation scare,” Hunt said at the van Eyk annual conference in Sydney yesterday.



“We have two risks to the financial markets this year: there’s tightening of policies, slowdown in Europe, but what I think is much more predictable [is] high Asian inventories, Asia devalues and then if you see those Asian currencies weakening, then within three months we’ll have a global deflation scare.



“We all buy our consumer goods made from Asia and if it starts devaluing, those goods will get cheaper and consumer price indices around the world start heading to zero, you get a deflation scare and you know what that does to markets, so watch those Asian currencies.”

But now ECB policymakers are keenly aware that inflation in their 17-country euro zone risks slipping further below their target of just under 2 percent, even if they insist deflation is not a threat.



The concern - which will add to pressure for the bank to cut interest rates or take other "easing" actions - has been highlighted by a slide in Greek inflation to below zero.



So far Greece, which entered deflationary territory in March for the first time in 45 years, is an isolated case. But price pressures are weak elsewhere in the euro zone periphery once tax rises are discounted.

In Portugal, annual inflation is running at 0.5 percent, although Nordea analyst Holger Sandte calculates consumer price inflation measured at constant tax rates is just 0.3 percent there. It is at 0.7 percent in neighboring Spain, he says.



"Given the recession, rising unemployment and tight fiscal policy in these countries, it would be no surprise at all to see rates below zero at least for a few months this year," said Sandte, one of a batch of analysts to put out research notes in recent days on the risk of a drift towards deflation.



Even in France, inflation slowed to 1.1 percent in March and Germany was at 1.4 percent...

Austerity and the world economy are putting a lot of pressure within the European community. The focus has been on austerity measures to rebalance their budget, but it did only accelerate the downturn and created more unemployment.

​

"You look at today's unemployment rates, and you look at the fiscal policy going forward - it's tight and it's tightening. That points to deflationary risks going forward," said Andrew Bosomworth at PIMCO, the world's largest bond fund.

​

Unemployment is running at 27 percent in Greece, 26 percent in Spain, and 17 percent in Portugal. The rate for the overall euro zone is running at 12 percent.

​​

​In the Euro area, the number of employed persons fell to a level not seen since 2006 as shown by the graph below...

And growth has been negative since 2012 ( measured by the GDP ) as shown by the chart below...

And even house prices have sarted to decline in the EU area : House prices, as measured by the House Price Index (HPI), fell by 1.8% in the euro area and by 1.4% in the EU in the fourth quarter of 2012 compared with the same quarter of the previous year, according to data published by Eurostat, the statistical office of the European Union.

​

Compared with the third quarter of 2012, house prices fell by 0.5% in the euro area and by 0.7% in the EU in the fourth quarter of 2012.