Deflation remains biggest threat to Euro Zone

Deflation remains biggest threat to Euro Zone
Mario Draghi, president of the European Central Bank (ECB), decided to keep interest rates unchanged at the central bank's monthly monetary policy meeting last week. This came as a surprise to the market, which was expecting the ECB to it ease further, and drove the Euro past 1.36 against the dollar in London's afternoon trading session.

The Euro was trending lower and in a narrow 100 percentage in point (pip) range between 1.34 and 1.35 over the past couple of days, indicating that the consensus view was for the ECB to ease interest rates to combat deflationary pressures arising in the Eurozone.

Preliminary data showed headline inflation falling to 0.7 percent in January, matching the October low that prompted the ECB to cut its main policy rate to 0.25 percent. This is well below the ECB target of "close to but below 2 percent". Further, in countries such as Greece, the inflation rate is already negative, while it ranges between 0.2 percent to 0.3 percent in Spain, Portugal and Ireland.

There is a genuine fear among economists that this prolonged period of low inflation could lead the Eurozone into the deflationary trap Japan found itself in for much of the last two decades.

The Eurozone is coming out of a sovereign debt crisis and deflation will hinder the debt-to-GDP ratios of the leveraged periphery countries to stabilize to healthy levels as deflation eats into the nominal growth of the economy. In a typical deflationary cycle, consumers hold back on purchases as they wait for goods to become cheaper -- in turn, causing growth to stall and debt burdens to rise further.

At the press conference last week, Draghi did not express any major concerns over the looming deflationary prospects, the emerging market crisis, the tightening money markets in Europe or the economic outlook for the rest of 2014. He did however acknowledge the improving consumer demand and rising business confidence.

Although there was no talk of deflation at this meeting, it remains certain that the ECB bias is still toward more easing -- whether it is done through another round of long-term refinancing operations (LTRO) or slashing the interest rates further. Draghi has categorically admitted in the past that he is ready "to do whatever it takes" and keep rates low for a prolonged period of time to combat the risks of low inflation and slow growth.

The silver lining for global equities against the deflationary backdrop in the Eurozone is that monetary policy will continue to remain easy in the coming months as long as a sustainable uptick in inflation data is not seen in the Eurozone.

Further, as the effects of the sales tax hike kick in Japan (effective April 1, 2014), it is widely expected that Prime Minister Shinzo Abe will inject more liquidity in the system by increasing Japan's own quantitative easing program. Japan's stimulus package, which is larger than that of the US Federal Reserve, considering the size of Japan's economy, currently involves purchases of bonds worth $70 billion a month.

Thus, if the Fed taper was the reason for the recent correction in the global markets, then the recent fall must make a great buying opportunity. Easy money will be pumped in by the ECB and the Bank of Japan in order to address their respective domestic economic worries.

Market participants should remain bullish on their long positions for the rest of 2014, especially in Europe, as it is hard to drown in a sea of liquidity.

(10-02-2014 Vatsal Srivastava is a senior market analyst. The views expressed are personal. He can be contacted at

Read more about: deflation, biggest, threat, euro, zone, special, ians
Story first published: Monday, February 10, 2014, 10:54 [IST]
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