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Monday, March 30, 2009

Eurozone Retail Sales Contract For the Tenth Month In Succession

The Bloomberg Euro-Zone Retail Purchasing Managers' Index - based on a mid-month survey of more than 1,000 executives in the euro area retail sector - rose marginally in March - to 44.1, up from 42.3 in February to 44.1 in March. This was the smallest monthly drop in the value of sales in five months, but it was still a drop, and quite a significant one, since the neutral point between contraction and expansion is 50. Still first quarter retail sales have seen an average monthly decline which is smaller than in the fourth quarter of last year (an effect of all those stimulus programmes), however sales have now fallen for ten consecutive months.

The German Sales Contraction Accelerates

Retail sales in Germany, the zone's largest economy, dropped for a 10th month in March as unemployment rose and manufacturing industry continued to grapple with a slump in export orders. The retail PMI dropped to 44.4 from 45.4 in February.

German households are cutting spending as a deepening economic slump forces companies to eliminate jobs, pushing up unemployment. The fall comes despite the decision of German Chancellor Angela Merkel to spend about 82 billion euros in measures to stimulate growth, including tax breaks and incentives to buy new cars.

“Consumers were generally unwilling to spend, while evidence of shorter working hours at local companies reportedly curtailed their buying power,” Markit said in the statement. “The overall decline may have been greater were it not for government incentives to scrap old motor vehicles, which continued to support sales in the automobile sector.”

The Italian Sales Contraction Enters Its 25th Month

Italian retail sales contracted for a 25th month in March as the country's worst recession in more than 30 years prompts companies to cut jobs, in the process eating away at consumer demand. The index was up slightly at 41.9, from 38.2 in February.

Italy slipped into its fourth recession since 2001 last year, sending the unemployment rate to a two-year high. The government has adopted around 40 billion euros in stimulus measures, but is constrained from spending more due to the high level of prior government debt. As a result the OECD forecast the economy will likely contract by 4.2 percent this year.

French Sales Hold Up A Little Better

France also saw a moderation in the rate of sales decline, with the pace easing from February's record but remaining steep. Month-on-month the index rose from 42.6 to 45.7, rounding off a first quarter that has seen the weakest sales performance in the history of the French survey. French retailers have reported falling sales in five of the past six months.

Tuesday, March 3, 2009

Eurozone Inflation Expectations Fall As The Output Gap Rises

It’s a depressing spectacle: on both sides of the Atlantic, policy-makers just keep falling short — and the odds that this slump really will turn into Great Depression II keep rising.

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.

Oh, and Jean-Claude Trichet says that there is no deflation threat in Europe. What’s the weather like on his planet?
Paul Krugman, yesterday

What follows here are simply a few charts to illustrate further the argument I developed yesterday as regards the significance of the deflation threat which now exists in the eurozone. The argument is that the ECB is once again being far too cautious, and risks allowing the entire eurozone to entire a deflationary cycle which may prove to be a lot harder to get out of than it was to get into. In my view the ECB should bring the refinancing rate close to zero % at next Thursday's rate setting meeting, and then explore what measures can be taken to introduce a zonewide version of US/Japan style Quantitative Easing as quickly as possible.

The key argument I am presenting is that it is a mistake to focus at this point on what is happening to energy, food and other commodity prices. The key issue is what is happening to core prices, and what will continue to happen to them as output contracts further. The other side of the coin are inflation expectations, and as we will see below these are now falling rapidly across Europe. It is very important at this point that these expectations do not get "locked in" to price fall expectations.

It is evident that the degree of economic slack in the OECD is now widening rapdily as unemployment rises and capacity utilization falls. The OECD output gap (the difference between current levels of output and some estimate of what "capacity" output could be at this point) continues to widen and is now only second in importance to the output gap seen in the early 1980s. In fact, the output gap is likely to have widened further since the OECD last made its forecasts in November 2008 (the OECD leading indicator has, for example, continued to decline since that point) but the output gaps shown for the US, the UK and eurozone in the chart below are already sufficiently pronounced to make the point quite clearly I think.

In fact, spare capacity is a phenomenon which extends way beyond the OECD, and economies throughout the world are operating at below their potential and look set to do so for both the remainder of this year and most of 2010. Global manufacturing has been contracting and global trade has collapsed. Here is the latest JP Morgan Global Manufacturing PMI.

The IMF currently estimates that the cumulative global output loss relative to potential over the period 2008-2010 will be as much as 5% (see chart below).

And inflation expectations are falling rapidly. The latest findings in the European Commission’s own consumer questionnaire show that the net balance of respondents in the UK and the Euro zone expecting prices to be higher this time next year is now at the lowest recorded level - just 2.7% and 4.1% respectively ( see chart below).

Monday, March 2, 2009

"There Is No Deflation Threat In Europe" - Jean Claude Trichet - Oh Really!

He's at it again. Last year he was busily trying to worry us all that inflation was set to get completely out of hand among the 16 countries who make up the eurozone. Now the President of the European Central Bank, Jean-Claude Trichet, is hard at it on another tack and is busying himself trying to convince us that there is no credible deflation threat facing these countries. Apart from getting it wrong on both occasions, the common point here would be a certain inbuilt "inflation bias", a bias which was earlier called "the original sin of the Bundesbank" by nobel prize winning Italian economist Franco Modigliani.

"There is presently no threat of deflation," Trichet told a committee of the European Parliament on Wednesday 14 February. "We are currently witnessing is a process of disinflation, driven in particular by a sharp decline in commodity prices." ..."It is a welcome development," he said, adding that the fall in energy, and other prices should help boost struggling economies.
Apart from manifesting a spectacular lack of economic judgement, the Financial Times's Banker of the Year 2007 is now forcing us to ask the embarassing question as to just how far "out of touch" you can get with the material you are supposed to be handling and continue to hold down your job. It seems we are forced to come up with the rather worrying response, that, in the case of the principal EU institutions (remember the sad case of Economy and Finance Commissioner Joaquin Almunia), the answer is "bastante" (consideably), since a quick look at the data we have to hand shows us that Eurozone inflation is already significantly undershooting the European Central Bank’s own target (and principle policy objective) of maintaining the annual rate “below but close” to 2%. Worse, by all appearances the rate of consumer price inflation in the eurozone is now set to head straight off into negative territory.

If we look at headline HICP inflation on an annualised basis, we will find that it fell more than expected in January - to 1.1 per cent, according to Eurostat data - down quite dramatically from the peak of 2.7 per cent hit in March last year. This was the lowest level we have seen since July 1999, and a sharp drop from the 1.6 percent rate registered in December. On a month-to-month basis, prices were down 0.8 percent. The "core" inflation rate - that is consumer inflation without the volatile elements of food, energy, alcohol and tobacco - we find it still stood at 1.6%, since the biggest impact on headline inflation comes from the decline in food and energy costs. But if we look at the monthly movement in the core index, we find that it dropped by a very large 1.3% (see chart below).

Now if we come to look at the core inflation rate over the last six months, we find that the index has only risen 0.1% (or an annual rate of 0.2%). This gives us a much more accurate reading on where inflation actually is at this point in time, and where it is headed. The chart below shows the six month lagged annualised rate for the last twelve months, and the sharp drop in January is evident. If things continue like this, then the eurozone as a whole is headed straight into deflation, for sure.

Why Should Prices Continue to Fall?

So what are the grounds for thinking that inflation may be now heading into negative territory (ie that we are entering deflation right now), despite the fact that the ECB revised forecast is likely to come out at about 0.7 per cent this year and 1.5 per cent in 2010, according to estimates from Julian Callow, European economist at Barclays Capital. Well let's look at a chart produced by Paul Krugman showing the relation between the US output gap and the inflation rate.

Now as Krugman explains the figure plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. (Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007).

The fit, as he says, is not perfect, but the correlation is evident, and there is an implied slope of about 0.5 — that is, every percentage point by which real US GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year. Now I am not going to advance here estimates of the present output gap in the eurozone, but we do have clear indications of a sharp and ongoing contraction in demand in the GDP numbers. Eurozone GDP contracted by 0.2% between the second and the third quarters of last year, and by 1.5% between the third and fourth quarters.

What's more the key indicators suggest that the contraction is accelerating at this point. The February Markit euro-zone composite PMI reading dropped to a record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one, and considering (as mentioned previously) that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). For those of you who simply don't believe that PMIs can tell you so much, take a look at Markit's own chart (below), showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. The results they achieve are pretty impressive I would say.

and if we look at an additional indicator (the EU's own Economic Sentiment Indicator for the eurozone) we will see that it hit yet another low in February (see below) which again suggests that the contraction is accelerating at this point, and substantially so.

So the core HICP index is on the point of turning negative on a six monthly basis, and the situation appears set to get even worse, and our Central Bank President assures us that "there is presently no threat of deflation". So which world am I living in, or which is he?

There are further reasons to anticipate a sharp downward pull on prices from some countries in the zone (like Spain and Ireland), since they have housing and construction booms which are in the process of unwinding, and the only way they can recover the competitiveness they have lost is by conducting a sharp and significant downward revision in prices and wages (since in a currency union there is effectively no currency to devalue). The two charts below show the loss of competitiveness experienced by the Irish and the Spanish economies (respectively) with regards to the German economy since 1999 as measured by real effective exchange rates (REERs).

REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators are deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness.

Now the eurozone being a common currency area presents us with specific problems in the context of deflation since, as the Irish economist Philip Lane argues a member of a currency union comes up against a natural limit in national-level deflation. Thus, he argues, while a country like Ireland may well face a sustained period of inflation below the euro area average (such that it may be negative in absolute terms for a greater or lesser period of time), the situation should tend to be self-correcting since the deflation implies an improvement in competitiveness, which should generate a boost in export driven economic activity and, over time, a return to an inflation rate at around the euro area average. I'm not sure that this argument is 100% valid, since sufficient internal demand lead deflation can so effect household and corporate solvency that debt deflation can at the very least send a country off into a sizeable and significant correction (say a decade long one) before the price level falls sufficiently to generate sufficient export activity to offset the decline in domestic demand and enable balance sheets to recover. But going into all this would get pretty wonkish, so, leaving that rather theoretical point aside, lets think about a more rather concrete and immediate reason for worrying about what is happening at the present time in the eurozone, and that is the possibility that the inflation and competitiveness benchmark country, in this case Germany, may itself be about to experience an internal price deflation process which is every bit as sharp as the fall in prices which is taking place in those economies which are supposed to be correcting vis-a-vis Germany itself. That is, let's consider the possibility that through this mechanism the deflation may become eurozone wide, and relatively self perpetuating, if something is not done to break the cycle.

So, if we now go on to look at the two relevant charts below (for Spain and Ireland) we will find that in each case core indexes are falling more or less in line with the German one. In fact, both the Spanish and the German indexes are unchanged over the last six months, the Irish one is down 0.5%. At this pace (a 1% a year differential with Germany) Ireland would recover its 1999 comparative position vis-a-vis Germany in around 30 years, a rather lengthy process to say the least.

But the point here is not that prices are falling in Ireland and Spain (they have to do this) but that prices are also set to fall in Germany, and this is where monetary policy from the ECB becomes vital, since if Germany is allowed to fall into deflation then it will be extremely difficult for Spain and Ireland to "correct" (the drop in wages and prices would have to be sharp indeed) but also monetary policy from the ECB would be in danger of becoming a complete mess.

Of course not everyone on the ECB governing council shares Trichet's rosier-than-rosy view, and in a comment that offered an insight into how at least some ECB council members are thinking, Mario Draghi, Italy’s Central Bank Governor said recently that “the governing council is keeping a close watch on the real cost of money”. What he means is that, if Spain's 1.5% drop in core prices over the last three months turned into a 6% annual drop, then the real rate of interest currently being applied would be around 8%, which would constitute a very tight monetary policy in the context of Spain's worst recession in living memory.

Perhaps some readers may feel I have been unduly hard on Jean Claude Trichet in this post, but I would simply close by reminding everyone of the conclusions reached in a once widely quoted paper - Preventing deflation: lessons from Japan's experience in the 1990s, by Alan Ahearne, Joseph Gagnon, Jane Haltmaier and Steve Kamin (2002) - where the authors argued:

We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

As some economist or other I read is in the habit of saying "history has a nasty habit of repeating itself, the first time as tragedy and the second time as tragedy". Or put another way, here we go again. Hello, is there anyone out there?