The specter of deflation

As the debate about the risks of deflation in the industrialized world heats up and the Federal Reserve rushes to cut its targeted interest rate by half a point to 1.25 percent, the lowest in 40 years, in order to invigorate the US economy, Greece’s consumer inflation was surprisingly on the upside in October, leading most economists to think that deflation is not a problem. Although it is not likely in the next year or so, there is a possibility that this conclusion may turn out to be wrong a few years from now, provided deflation asserts itself in the large eurozone countries. Greek national consumer price inflation rose to 3.7 percent year-on-year in October from 3.5 percent in September, forcing economists to revise upward their forecasts for this year’s average inflation to 3.6 percent from 3.5 percent or even lower. Higher-than-expected fresh produce and fuel prices contributed significantly to this outcome, as evidenced by core inflation’s fall to 3.5 percent last month from 3.7 percent in September, according to EFG Eurobank’s chief economist Plato Monokroussos. Greece’s EU-harmonized inflation inched higher to 3.9 percent year-on-year in October from 3.7 percent the previous month, as the eurozone’s average inflation is estimated to have edged up to 2.2 percent year-on-year in October from 2.1 percent in September. This means Greece would not have met the price stability criterion if the EMU authorities were to examine its application for membership today, since each candidate country’s average inflation should not have exceeded the average of the three best performing countries by more than 1.5 percentage points. Of course, Greece would not have been the only EMU country to fail this test. Spain, the Netherlands, Portugal and Ireland would also have fallen into the same category. It should be noted that the failure of these five countries to meet the Maastricht criterion on inflation partially explains why Euroland’s average inflation has not fallen in the European Central Bank’s (ECB) 0-2.0 percent target range. These five countries account, after all, for 21 percent of the eurozone’s harmonized consumer price index. Given the country’s high inflation rate, it is easy to understand why the worldwide debate on deflation has not caught fire in Greece. Still, the specter of deflation, which has been raised by many well-known economists, most prominently by Morgan Stanley Chief Economist Stephen Roach, has been discussed extensively around the world and though many have yet to be persuaded that this is the case, there seems to be a consensus that the risks of a protracted economic slowdown far exceed the risks of inflation, calling for more aggressive monetary easing, especially by the ECB. To some extent, Greece’s relatively higher inflation can be attributed to cyclical factors, as strong domestic demand underpins healthy GDP growth in the order of 3.5 to 3.8 percent this year. However, other structural factors, such as limited competition in certain goods and services sectors, especially those shielded by international trade, also account for this rigidity, aided by rising unit labor costs as nationwide wage growth spreads to non-tradable sectors experiencing traditionally lower productivity growth. Oil price hikes have also proved to have strong secondary upward effects on inflation even months after the hike. Stubborn inflationary expectations have also played a role in keeping Greek inflation high, since they are formed in a pro-growth macroeconomic environment sprinkled with sometimes generous collective bargaining agreements. Still, Greek inflation is expected to drop next year, starting from January, in line with the other countries in the eurozone. Greek inflation is seen as falling below 3.0 percent year-on-year in January 2003, while average eurozone inflation is expected to drop to 1.6 percent from an estimated 2.0-2.2 percent at end-2001 in the absence of a shock in the food and energy sectors. It is to be remembered that adverse weather conditions pushed food prices higher in Greece and other Eurozone countries in January 2002, while crude oil prices also rose by about 10 percent the same month and the changeover to the euro currency also added to inflation. Moreover, assuming normal weather conditions and a predicted deceleration in unit labor cost growth, to the tune of 2.0 percent in 2003 versus an estimated 3.1 percent this year, known to filter through to prices in the non-tradable goods and services sectors, Greek inflation should nudge much lower, perhaps proportionately more than the average inflation in the eurozone – forecast at 1.7 percent in 2003 versus an estimated 2.2 percent in 2002. Still, one would quickly observe that even average inflation on the order of 2.6 percent in 2003, considered by many as too optimistic, could qualify for the disinflation award, but not for deflation, which is associated with falling price levels of the kind seen in Japan and in the USA in the third quarter of 2002 where inflation, measured by the GDP deflator, is up just 0.8 percent year-on-year. This is correct. However, Greek disinflation will come on the heels of rapid economic growth, estimated at 3.0 percent or better, fueled by huge EU inflows, spending related to the 2004 Olympic Games, enacted tax cuts and low interest rates. If pundits are right that there is a high risk that the eurozone is about to enter a period of deflation, then the situation changes for the worse. First, it is accepted that Greece’s strong GDP growth may not continue post-2005 with the impetus provided by the spending for the 2004 Olympic Games’ infrastructure fading and the huge annual EU inflows linked to the third Community Support Framework funds destined to dry up in 2006. Therefore, a cyclical factor propping up inflation will not be there or will not be that potent. Second, assuming the eurozone is infected by deflation and traditional stimulative monetary or fiscal policy measures fail to cure it at the same time that the Greek economy grows and Greek inflation, although receding, exceeds the EMU average, Greece will see the competitiveness gap separating it from its major trading partners get wider. This will undoubtedly hurt its production base and lead to lost output and jobs, helping moderate inflationary expectations along the way. Although it is difficult to disagree with those who contend that Greece’s first macroeconomic priority should be to bring down inflation to improve its economy’s international competitiveness, there is a case to be made about the future risk of deflation. This is pertinent to eurozone’s large economies falling into the trap the way Japan has and the USA may do. Assuming this is the case, one should have no illusions about Greece’s ability to emerge unscathed from such a nightmare.