Eurozone Deflation Unlikely but Still a Risk, says Fitch

The risk of deflation is most significant, albeit still low, for the eurozone among the world’s major advanced economies (MAEs), according to Fitch Ratings’s latest assessment.

The credit ratings agency (CRA) said that eurozone inflation is already the lowest among MAEs, and policy options to respond to potential deflationary shocks are more limited than elsewhere.

Fitch predicts that the eurozone’s economic recovery will continue in 2014-15, with 1.1% real gross domestic product (GDP) growth this year and 1.4% next year, as in other MAEs. This would make an increase in domestic disinflationary pressures unlikely, as the CRA does not expect the negative output gap to widen further.

However, eurozone inflation last month was just 0.8%, compared with the European Central Bank’s (ECB) target of below but close to 2%. While the probable policy response by central banks is one reason for Fitch believing that prolonged deflation is unlikely in any MAEs, the ECB is near the zero lower bound of nominal interest rates, and could face political and legal challenges if it tried to embark on quantitative easing (QE).

In addition, regional inflation dispersion is limited. Inflation is below the eurozone-wide target in core as well as peripheral countries. The lower the average inflation, the longer and more costly will be the peripheral countries’ recovery of lost competitiveness.

Fitch estimated seasonally adjusted, quarter-on-quarter (qoq) annualised core inflation for the eurozone, US, UK, and Japan as part of its quarterly
‘Global Economic Outlook’
. Shorter-term rather than year-on-year indicators give an underlying indicator of inflation rates if recent trends persisted for an extended period. This indicator is lowest for the eurozone, at 0.7%-0.8%, slightly below that for Japan.

The CRA’s underlying indicator is close to core year-on-year inflation, suggesting that if there are no shocks a further decline in the eurozone’s core inflation is unlikely in the near term.

Nevertheless, the protracted adjustment in the periphery, combined with price and wage stickiness, would add to the costs of periphery rebalancing and increase the real value of the debt burden, and so could ultimately also add to deflation risks.

Overall, alongside likely central bank responses, Fitch believes a strengthening economic recovery and anchored inflation expectations make protracted, self-reinforcing deflation unlikely in the MAEs unless there are additional shocks.

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