Rising deflationary risks in the United States

Unlike a number of other nations - especially some countries in Europe - the US is currently not dealing with general price declines. However, the risks of such an occurrence have increased materially. This for example can be seen in the intermediate-term market-based inflation expectations, which have fallen to 2009 levels - when deflation was a serious concern.

One key data point supporting these rising risks came from last Friday’s jobs report. The report showed wage growth falling from a fairly stable level of 2% per annum.

In particular, “production and nonsupervisory employees” saw a sharp decline in wage growth - in spite of robust growth in payrolls (see chart).

Economists have been expecting the recent strength in US labor markets, including big increases in job openings (see chart), to translate into stronger wages. However, just the opposite has taken place.

Now, combine slowing wage growth with global disinflationary pressures and the collapse in energy as well as other commodity prices (see copper price for example). Below is the CRB commodity index.

Plus, as an additional data point, the PriceStats CPI trend (online-price-based CPI-tracking model) has fallen to 2009 levels.

Blue = actual CPI, orange = PriceStats index (h/t @jp_koning)

Putting it all together points to rising risks of deflation in the US. There is absolutely no way the Fed can raise rates in this environment. In fact some Fed officials are quite open about taking any 2015 rate hikes off the table.

Nevertheless, the markets still anticipate the first hike in late Q3/early Q4 of this year. This is somewhat surprising, considering that in the UK, for example, rate hike expectations have been shifted to 2016 (see chart).

It's not that a 25-50bp Fed Funds rate hike by itself will have much of an impact on the US economy. In fact short-term rates actually rose at the end of last year without most people even noticing (see post). Raising short-term rates in the US (while the rest of the world is on hold or lowering rates) risks pushing the dollar higher. And a much stronger dollar would exacerbate some of the trends discussed above, increasing the possibility of deflation in the US.

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Draghi now has all the ammunition he needs for QE. Implementation still a problem.

If Mario Draghi was lacking ammunition to initiate an outright quantitative easing program in the Eurozone, he certainly has it now. Even the staunchest opponents will have a tough time arguing against the need for a more aggressive approach to monetary easing. Here are five reasons:

1. The take-up on ECB's TLTRO offering (see post) fell far short of the ECB’s goals. Indeed the demand in the second round of the offering came in at €130 bn, putting the total take-up at €212bn - well below the €400 billion allowance. Since the TLTRO financing is linked to bank lending, the program to some extent relies on demand for credit from businesses and consumers. And that demand has been lackluster in the past couple of years. Therefore the initiatives announced by the ECB last summer, including ABS and covered bond purchases, are simply insufficient for the type of monetary expansion (of about €1 trillion) the central bank would like to see in the Eurozone.

Eurosystem consolidated balance sheet (source: ECB)

2. Some Economic data out of the Eurozone shows recovery stalling. Italian industrial production and French labor markets are just two examples.

Source: Investing.com

Source: Investing.com

3. With the collapse of oil prices, the Eurozone is bracing for deflation. German 5-year breakeven inflation expectations are now at zero. And Europe's central bankers are fearful of repeating Japan's decade-long struggle with deflation.

Source: @PlanMaestro

4. While the euro has declined significantly against the dollar, it remains quite strong on a trade-weighted basis. This is putting downward pressure on prices (via cheaper imports) and is disadvantaging some of the Eurozone-based exporters. A more aggressive easing effort would force the euro lower.

TWI = "trade-weighted index" (source: @TenYearNote)

5. Finally, the euro area's sovereign risks are resurfacing once again - triggered by new political uncertainty in Greece.

The Guardian: - Mounting concerns over Greece’s ability to weather a presidential election, brought forward in a surprise move by the prime minister, Antonis Samaras, continued to unnerve investors ahead of the first round of the vote in the Greek parliament next week.

Under Greek law failure to elect a new head of state by the ballot’s third round on 29 December could trigger a general election. The stridently anti-bailout main opposition party, Syriza, is tipped to win that poll. The radical leftists have made a debt writedown and the end of austerity their overriding priorities if voted into office.

Although Samaras called the election in a bid to expunge the political uncertainty engulfing Greece, the slim majority held by his government, compounded by the leader’s repeated warnings of Greece leaving the eurozone if Syriza assumes power, has accelerated investor nervousness.

The nation's stock market is down 20% over the past 5 days as investors flee.

red = Euro STOXX 50, blue = Athens Composite

And Greek sovereign debt sold off sharply. In fact the 3-year government paper yield went from roughly 3.5% in September to 11% now. This situation alone would make most central bankers consider some form of monetary easing.

Mario Draghi now has five solid reasons to argue for QE and many expect the central bank to announce such an initiative in the next 2-3 months. However, while most economists covering the euro area agree on the need to take a more aggressive monetary action, the problem of implementation remains. Since the Eurosystem's (ECB's) balance sheet is in effect owned by member states, many in the core economies are worried about having to become the proud owners of large quantities of their pro rata share of periphery nations' debt. For the Germans in particular, the ownership of such debt is a major issue. A solution that is even remotely politically palatable across the Eurozone remains elusive. The ECB's independence and the euro area's legal structure is about to be tested once again.

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The Fed's policy trajectory is tied to global recovery

The latest US payrolls report presents a challenge for the Fed. As discussed back in April (see post), US labor markets are continuing to heal, suggesting that the rate "normalization" should be a serious consideration for the central bank. However the recent deterioration in commodities, especially energy, is "importing" global disinflation to the US (see post). In particular, the Saudi commitment to retake lost market share has sent shock waves through the oil markets (see post).

GCC is a diversified commodity index (source: barchart)

As a result, longer-term market-implied inflation expectations have fallen substantially.

The latest declines in expectations came after the recent FOMC minutes already showed increasing concerns at the central bank:

FOMC: - “Many participants observed the committee should remain attentive to evidence of a possible downward shift in longer-term inflation expectations.”

At the same time payrolls in the US are growing at a rate approaching the pre-recession peak (though still materially below what we saw in the 90s).

In fact the divergence between payrolls growth and inflation expectations is currently unusually high. Payrolls are driven by stronger US domestic economy, while inflation expectations are impacted by external factors, which creates this disconnect.

Red dot represents the current situation

This mismatch is causing a dissonance for policymakers and market participants, adding to the disagreement on the timing of liftoff. Current market expectations for the first hike now point to Q3 of 2015.

Source: CME

However if inflation expectations persist at these levels or worsen, it will be nearly impossible for the Fed to move on rates - irrespective of how much labor markets improve. The bet represented in the chart above is that energy prices will stabilize and/or growth in wages improves substantially by next summer - pushing breakeven expectations higher. But such an outcome, driven to some extent by factors external to the US, is far from certain.

What makes the timing of liftoff particularly difficult to estimate is the value of the US dollar.

Source: barchart

With a number of major central banks either easing or expected to begin easing monetary policy (diverging from the Fed), the rise in the relative value of the dollar will continue. That will bring inflation expectations even lower by weakening US import prices and pressuring commodities. If the strong dollar can make goods and to some extent services from abroad cheaper, there is less incentive for US-based firms to raise wages. Tapping cheaper markets abroad becomes more profitable.

And as the expectations of liftoff draw closer, the dollar will strengthen further, making it more difficult for the Fed to pull the trigger (what some refer to as a "self-correcting" mechanism). It's hard to envision the Fed acting unilaterally in the sea of looser monetary policy worldwide. The policy trajectory of the US central bank is therefore tied to a large extent to the global recovery, which remains elusive for now.

The Fed officials are keenly aware of premature policy tightening by a number of central banks, who were forced to reverse their decisions later.

Source: @themoneygame (Business Insider), Deutsche Bank

What some of these central banks didn't count on was the global nature of disinflation, over which they had little or no control (see chart). In the Fed's case, such a reversal would severely undermine the FOMC's credibility, sending policymakers back to the drawing board.
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The Fed concerned about "importing" disinflation

The latest Reuters poll is showing 24 out of 43 economists projecting the first rate hike in the US by June of next year. The futures market is pricing liftoff by September. Citi's latest analysis puts it in December. And all of these forecasts are running way behind the so-called Taylor Rule, which is suggests that the Fed Funds rate should already be at 1.5%.

Source: @Schuldensuehner, Citi

In fact the US economy can easily handle non-zero short-term rates at this point. The banking system is quite healthy and can easily manage funding costs of 1.5%. Corporate borrowers can deal with slightly higher rates as well. And as far as mortgages are concerned (to the extend higher short-term rates extend to longer maturities), borrowers for whom payments become prohibitive at 5% vs. 4% should not be taking out a mortgage to begin with. Furthermore the issue with the housing market these days has more to do with tighter mortgage credit rather than rates.

But it's no longer as much about the US economy as it is about external factors. The international situation has made the Fed's policy planning much more complex. The monetary policy divergence among the major central banks is the issue at hand. With the BoJ suddenly accelerating its QE program, the PBoC cutting rates, and Mario Draghi hinting at a potential QE program in the Eurozone, the Fed is becoming increasingly isolated in its plans to begin rate normalization. Even India's RBI, who has kept rates elevated for some time, may begin to ease soon as the nation's inflation and money supply growth slows.

As a result of this divergence, the US dollar has been on the rise this year.

Of course the recent increase in and of itself is not tremendous relative to historical levels. However, given the disinflationary pressures around the world, the rising US dollar effectively "imports" disinflation into the US. Moreover, the massive drop in energy prices, caused by a combination of a significant rise in North American production and weaker demand globally (as well as the Saudi "dumping"), is adding to slower inflation. In fact, in recent months a paradigm shift has taken place. Weakness in inflation is no longer viewed as a temporary phenomenon as the longer-dated market-based inflation expectation measures turn sharply lower.

Furthermore, professional forecasters are also downgrading their long-term inflation projections.

Source: Deutsche Bank

Even consumer expectations of long-term inflation have shifted.

Reuters: A Thomson Reuters/University of Michigan survey released last week showed that consumers see inflation averaging 2.6 percent a year five to 10 years from now, down from 2.8 percent predicted last month and the lowest reading since March 2009.

It's not going to be about jobs going forward, in spite of the comments we continue to hear from the FOMC. The Fed's focus has shifted to inflation and inflation expectations. And no matter how low the unemployment rate falls, it will be difficult for the Fed to pull the trigger on rates, risking further strengthening of the dollar and more downward pressure on prices. It is possible the Fed will wait for growth in other major economies to stabilize before liftoff in the US. Which is why some economists (like those at Citi) are pushing rate hike expectations further out in time. Unfortunately the longer it takes to get there, the more disruptive the effect of normalization will be on global financial markets - as the Fed's zero rate policy moves into its 6th year and possibly beyond.


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Disinflation spreads to the UK

Italian consumer inflation remains in the negative territory (see chart), as the nation's economy struggles to grow. But Italy is not unique - the rest of the world is catching the Eurozone's disinflationary flu. China's latest CPI print for example came in below that of the US - something we haven't seen until recently (see chart).

The UK is also facing weakening inflation. Prices continue to fall at the wholesale level, with British firms still having little pricing power (see chart). It's difficult to raise prices when everything is marked down across the Channel. For the UK's consumers, inflation is now at the lowest level since the Great Recession - for both the headline and the core CPI.

It's difficult to see how the Bank of England can begin raising rates in such an environment - even with the housing market remaining strong (see chart). With oil prices collapsing, inflation is only going to move lower. Just as the case with the Fed (see post), the forward rates markets are pricing in an increasing delay in liftoff. The BoE is on hold at least until next summer as disinflation spreads to the UK.

Markets' expectations of the UK overnight rate (source: BoE)

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Euro area staring at deflation as it waits for TLTRO

The ECB remains behind the curve in routing out the Eurozone's persistent disinflationary trend. The area's CPI is now below 0.5% on a year-over-year basis. Yesterday we saw German CPI hit new lows (see chart) and Italy's inflation rate is now hovering just above zero.

Investing.com

Bloomberg: - Euro-area inflation unexpectedly slowed in July to the weakest in almost five years, underscoring the European Central Bank’s concerns that the economy is too feeble to drive price growth.

Inflation was 0.4 percent compared with 0.5 percent in June, the European Union’s statistics office in Luxembourg said today. That is the weakest since October 2009 and below a median forecast of 0.5 percent in a Bloomberg News survey of 42 economists.

The centerpiece of ECB's latest policy initiative, the TLTRO program, will take some time to fully ramp up. In the mean time the central bank is staring at rising risks of deflation, which may end up being extremely difficult to fight (as the BoJ painfully learned over the years). The Eurosystem's (ECB) balance sheet continues to shrink to pre-LTRO levels resulting in tighter monetary conditions.

Eurosystem balance sheet (ECB)

The most expeditious action the central bank can take at this point is to further weaken the euro, and it has multiple tools to execute such policy. Whatever the case, the time for the ECB to act is now, not over the next couple of years.

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Eurozone's disinflation contagion in the UK

With the UK's property prices continuing to rise (see chart) and the labor markets improving (see chart), the only major factor that could force the Bank of England to delay the first rate hike until next year is the slowing inflation rate. Part of the issue for the UK is the "contagion" from the Eurozone. Half of UK’s trade is with Europe.

Source: ONS

It's hard for UK companies to raise prices when you have disinflationary pressures and declining labor costs across the Channel.

Source: Tradingeconomics.com

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Markets now expect shock and awe from the ECB

In recent months the ECB has been dismissing reports showing declining inflation in the Eurozone. Officials have been calling the situation "transient". "Just wait until after Easter," and all will be well... (see story). But today's inflation report out of Germany shows that there is nothing transient about euro area's disinflationary pressures.

Source: Investing.com

The ECB has little choice but to act at this point, and unless we see "shock and awe" from the central bank, global markets will be quite disappointed.

On a related note, the chase for yield and the anticipation of fresh monetary stimulus in the Eurozone has created a rather distorted global rates environment. Spanish 5-yr government bond yield is now below the 5-yr treasury yield. Real (inflation-adjusted) yields in Spain are of course still higher than in the US. But just to put things into perspective, almost exactly 2 years ago Spain was staring down a potential collapse of its banking system and was actively seeking bailout funds (see post).

Once again, without a "show of force" from the ECB, this is not going to end well.

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Swiss deflation

While the Eurozone is concerned about disinflationary pressures, Switzerland is dealing with outright deflation. Persistently strong Swiss franc and weak economic growth in the euro area are putting downward pressure on prices.

Switzerland PPI (source: Investing.com)

Some are suggesting that the Swiss National Bank follow the ECB's lead in (potentially) loosening monetary policy via "unconventional" tools. Otherwise it will become increasingly difficult to arrest these falling prices.

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ECB moving closer to unconventional policy

The ECB received another set of disappointing inflation reports today. For some time now the central bank has been betting on the fact the declining inflation figures were driven by food and energy, while the core CPI rate was recovering. Well, that didn't turn out to be the case, at least for now.

Eurozone core CPI (source: Investing.com)

With the euro remaining at lofty levels, the ECB is beginning to prepare the markets for new monetary stimulus, as the various officials discuss "unconventional" policy.

Weidmann:

BW: - After building a reputation as a nay-sayer on the European Central Bank’s Governing Council, the Bundesbank president’s [Jens Weidmann's] support for large-scale asset purchases marks a shift that helps the fight against deflationary threats. His tentative backing of quantitative easing will shore up its credibility as officials debate whether they need to implement it.

Coeure:

WSJ: - "Should further monetary accommodation be needed, it is reasonable to consider other operations aimed at lowering the term premium. This is where targeted asset purchases enter the toolset of monetary policy," Mr. [Benoit] Coeure said in prepared remarks to an International Monetary Fund conference.

Nowotny:

WSJ: - Mr. [Ewald] Nowotny, who is a member of the ECB’s governing council, signaled that his preference would be for any ECB stimulus to be geared toward Europe’s asset-backed securities market, which may in turn boost the flow of credit to the economy. He said he is open to setting a negative rate on bank deposits parked at the ECB, but raised doubts about the effectiveness of such a move.

“We are preparing all the technical aspects of a range of possible interventions,” Mr. Nowotny told The Wall Street Journal on the sidelines of meetings of the International Monetary Fund.

Of course there doesn't seem to be an agreement on the type of unconventional policy the central bank will undertake. Things like a negative deposit rate for example have been discussed. But if the decision is to buy assets, what types of assets would the central bank focus on? Some of the recent discussions centered around ABS securities and other types of bonds that would provide credit to smaller and medium-sized businesses. The problem with this strategy is the market size. Thanks in part to Basel capital rules, the ABS market in Europe isn't sufficiently large (Basel regulators have referred to these securities as "toxic"). And since only the higher rated paper qualifies for ECB collateral (which is presumably the only bonds that the central bank would be permitted to buy), there isn't enough to have a credible QE program.

Source: DB

It seems the ECB wants to stay away from simply buying sovereign debt, particularly of periphery governments (for obvious reasons). Buying only the core states' bonds on the other hand could be even more problematic. Moreover, lowering government bond yields is unlikely to stimulate private credit growth (after all it hasn't thus far). The central may also stay away from uncovered bank bonds for the same reasons it wants to avoid periphery sovereign paper. This leaves corporate paper - bonds and even direct loans to companies bought in the secondary market. Hard to imagine a central bank buying corporate paper, but it has been done in Japan, so why not in the Eurozone?

Deutsche Bank has compiled an excellent chart of the ECB's options based on the effectiveness of the purchases in stimulating growth (getting capital to where it is most needed) vs. the size of the QE program. The tricky part is that the more effective the monetary transmission, the riskier are the assets.

These are some difficult choices for the ECB and the central bank may want to wait longer to see if the inflation picture improves and/or the euro declines. It may however end up being a long wait.

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Renewed pressure on the ECB

Pressure continues to build on the ECB to act. As discussed earlier (see post), the central bank may remain on the sidelines for some time, but the latest developments (listed below) make this inaction increasingly difficult.

1. Declines in liquidity have been quite sharp. The Eurozone banks' excess reserves are still declining, touching the levels not seen in years.

Source: ECB

2. The French inflation report that came out today shows price increases which are materially below the central bank's target and seem to be trending lower (see chart). Disinflationary risks remain.

3. The euro is grinding higher, which is not great for the area's exporters and will put further downward pressure on prices.

EUR/USD (source: MarketWatch)

4. China's slowdown will also have a negative impact on the area's economy because China represents the Eurozone's third largest export market outside of the EU. The fact that China's imports unexpectedly fell by 11% is not great news for the euro area's recovery.

Source: Investing.com

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Disinflationary pressures beyond the euro area

According to the Conference Board, disinflationary pressures are not limited to the Eurozone and can be seen across a large number of the "developed economies". The so-called "Harmonized Indexes of Consumer Prices" or HICP (a measure of inflation that has been standardized based on the EU definition) seems to show consumer prices weakening broadly, with only a couple of exceptions.

The Conference Board: - “While the Euro Area has been nearing the deflationary boundary over the past several months, countries outside the monetary union are not spared that same concern,” said Elizabeth Crofoot, Senior Economist with the International Labor Comparisons program at The Conference Board. “Price growth is nearly zero in Denmark and Sweden, and has once again reached deflationary territory in Switzerland, last seen in May 2013. In contrast, after years of having the lowest inflation rate, Japan—together with Norway—is experiencing the highest inflation among the countries compared.”

Source: The Conference Board

In the US the TIPS market seems to agree with this assessment as the breakeven rates remain subdued (see chart). The HICP trend in the next two months will be critical. It will drive the monetary policy trajectory across key economies, particularly in the Eurozone which is now coming to terms with the possibility of QE (see story).

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Why is the ECB hesitating on monetary easing?

The Eurozone's unemployment rate is at 12% and holding while the area's youth unemployment is at staggering 24%. Private lending is still contracting (see post) and disinflationary pressures persist even within the "core" states (see chart). The price stability situation in the "periphery" is starting to look outright deflationary - see chart.  The euro is still at mulit-year highs, putting pressure on the area's export businesses. At the same time monetary conditions continue to tighten as the area's central banking system balance sheet approaches pre-LTRO levels.

unit = mm € (source: ECB)

Given the situation, most central bankers would take action. A simple policy change for example could be to suspend the sterilization of securities already held by Eurosystem - see post. But the ECB is hesitating. Why? Here are some reasons:

1. This may upset some folks but the reality is that the ECB is notoriously indecisive as it is pulled into various directions by the member states. Many forget that the institution is relatively new (just over 15 years in existence) and the shock of the recent crisis had left the organization a bit paralyzed. It rarely takes a decisive action unless it's forced by the markets to do so. The decision to "save the euro" only arose as Spain approached the point of "no return".

2. The ECB is also somewhat distracted as it prepares to take on the massive task of regulating the area's banking system - a responsibility that was not initially part of the central bank's charter.

3. The ECB does not have the dual mandate of the Fed and is only focused on price stability. The central bank views the area's horrible unemployment problem as being outside of its "jurisdiction". While technically correct, many central bankers would regard this narrow interpretation of the rules as shortsighted.

4. The hawks at the ECB continue to view the disinflationary pressures in the euro area as transient.

Reuters: - The ECB is running official interest rates at a record low but unlike other major central banks has resisted calls to follow that move with outright "quantitative easing" to pump more money into the economy.

[Bundesbank President Jens] Weidmann said that about two thirds of the falloff in euro zone inflation to 0.7 percent, the lowest since the economy was deep in recession in 2009, could be attributed to falls in energy and food prices.

"Monetary policy should respond to such factors only in the event of second round effects," he told a conference in Berlin, saying he would not talk about current monetary policy ahead of the ECB's monthly policy meeting next Thursday.

"With regard to the rate of inflation at the moment, the euro area is not in a self-enforcing downward spiral of price decreases, which is nominally the definition of deflation," he said.

5. The ECB has been heavily focused on the recent improvements in corporate growth, particularly the PMI indicators. Markit indices for example show a steady recovery from the 2012 lows.

Mario Draghi has been speaking about these improvements lately but he continues to ignore some warning signs hidden in these numbers.

Markit: - Policymakers will be encouraged by the survey in terms of the signs of sustained recovery. However, concerns will persist regarding the deflationary forces, especially in the periphery. With prices charged by manufacturers and service providers both falling again in March, there remains an argument for further stimulus, especially if the rate of growth of activity cools again in April.

6. The central bank is also hanging its hat on improving sentiment surveys in the euro area - see Twitter post. The thought is that if consumers and businesses are happy, credit growth will somehow stabilize. Perhaps. But the mood of these crisis-weary survey participants can easily turn if the area's labor markets do not heal soon.

7. The policymakers are also betting on the fact that the rapidly falling long-term rates in the Eurozone periphery will provide some "natural" stimulus to the area's economy. Indeed, as the markets perceive lower risks of default, the yield declines on longer-dated periphery sovereign paper have been quite spectacular. The OMT backstop provided by the ECB has certainly helped.

Source: Investing.com

The reason behind these recent sharp declines in yield however has to do with bets on disinflationary pressures and a subsequent easing action by the ECB.

Reuters: - Spanish, Italian and Portuguese bond yields hit multi-year lows on Thursday, with speculation about further European Central Bank monetary policy easing prompting investors to seek the bigger returns offered by lower-rated assets.

Should the ECB fail to act, these yields will inevitably rise. It is also important to note that low government borrowing costs are no guarantee of stimulus to the private sector. The private sector can not or is unwilling to borrow, reducing the impact of lower benchmark rates.

Ultimately the ECB could be right and some day, as the banking system is "restructured", the Eurozone's economy will heal itself. But that was also the attitude in Japan years ago when the nation undertook its banking reform. Yet deflation in Japan persisted for years since then, becoming heavily entrenched in the economy. Is the ECB now willing to take that chance?

Update: More CPI results from the Eurozone are out this morning.

a. Here is the latest aggregate euro area CPI result.
b. Below is the CPI measure for Italy:

Source: Investing.com

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The ECB receives another disinflationary warning

The ECB received another warning today: the German CPI rate came in below expectations. The disinflationary pressures are no longer just about the Eurozone periphery.

Source: Investing.com

Moreover, the euro area private loan balances continue to contract and the broad money supply growth remains weak.

Reuters: - "Weak money supply growth is not only condemning the euro zone to stagnant recovery, but it is raising the odds that the single-currency area could easily slip back into recession again," said David Brown at New View Economics.

"The ECB still needs to think outside the box to get the euro zone motoring into the fast-lane," he added. "A change of heart on quantitative easing still beckons ahead."

The ECB, worried that inflation risks getting stuck in a "danger zone" below 1 percent, is considering whether to take fresh policy action next Thursday to support the economy.

Bunds rallied on the news, with the market still anticipating an easing action from the ECB. The 2-year German note yield dropped down below 10bp again.

Source: Investing.com

While the ECB has been counting on improving business confidence in the Eurozone to stabilize the recovery, surveys may end up being misleading. With a great deal of the euro area expansion relying on exports and China's (and other EM nations) growth slowing, sentiment can turn very quickly.

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ECB still ignoring the disinflationary trend

So far the ECB has not responded to the disinflationary risks building in the euro area. Some Governing Council members dismissed the calls for action from numerous economists, referring to the analysts' reports as the "Anglo-Saxon" irrational fear of deflation. Perhaps. But is doing nothing then a "rational" policy? While the ECB has been on the sidelines, the balance sheet of the Eurosystem has been contracting fairly sharply - all in the face of unusually tight credit conditions (see post).

While many Governing Council members insist that the recent trend of below-target inflation is transient, the data tells us otherwise. For example, the latest report shows the German PPI consistently in the red for several months in a row.

Source: Statistisches Bundesamt

Similarly the French CPI figures are also significantly below historical averages, with the core rate declining particularly quickly.

In isolation these disinflation signals may be fine, but on the whole the trends across multiple countries could spell trouble. This is especially important as China's economic growth slows (see story), making it more difficult for the Eurozone to export its way into stronger growth (as some member nations have been doing). An economic slowdown in the Eurozone at this stage could tip the balance, pushing the whole euro area into a deflationary environment.

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