This article was originally published 19 November 2014 on ft.com.

Japan shows costs of acting too late on deflation risk

Here is a thought experiment. What do you think inflation is going to be in the US or the UK seven years from now? While we believe it is not possible, in any serious way, to forecast annual inflation that far ahead, the most sensible answer is 2 per cent: the Federal Reserve’s and the Bank of England’s inflation targets. These are credible central banks.

What about the eurozone? Is the European Central Bank’s inflation target of close-to-but-below 2 per cent credible? That is not so clear. Mario Draghi, ECB President, is right to highlight the decline in longer-term inflation expectations in the eurozone as a worrying development that demands action.

To the extent that the eurozone has a growth strategy, it is to hope for external demand to propel exports. But Asian demand has weakened. The Ukraine-Russia crisis will affect eurozone growth. Eurozone domestic demand growth is depressed. Fiscal policy is less of a drag, but countries with room for fiscal expansion are reluctant to use it.

While the eurozone may avoid a third technical recession, in practical terms it has not emerged from the recession that started in 2008. If you apply the same criteria to the eurozone that the US National Bureau of Economic Research uses for judging US business cycles, then this realisation is very clear. In this context, it should be no surprise that the eurozone is so close to deflation.

In the year to October, eurozone headline inflation came in at 0.4 per cent. In December, the ECB is going to have to revise down its inflation forecasts again – something that has become a quarterly ritual. It will be interesting to see if the ECB has enough confidence to forecast inflation at 2 per cent in 2017, when it adds the third year to its forecast.

This is not just a matter of adjustments needed in peripheral countries: inflation is dangerously low in the core, too. Nor is it just a matter of lower energy prices. Core inflation, excluding food and energy, was just 0.7 per cent in the year to October. While certainly not complacent about the ECB’s inflation target, Mr Draghi is constrained by eurozone co-ordination problems and a recalcitrant Bundesbank. Still, he has been able to build a strong case for action, based on the risk to medium-term inflation expectations and explained in terms of the size of the ECB balance sheet.

The ECB is already engaged in quantitative easing (QE) via its covered bond purchases and the planned purchases of asset-backed securities. But these are likely to be small programmes, and the same would apply if the ECB bought corporate credit. The most practical way to expand its balance sheets via asset purchases is by buying government bonds, just as the Fed and BoE did.

QE would certainly be more powerful if combined with fiscal expansion, where possible. And structural reform is needed to promote higher potential growth rates in the medium term to ensure long-term eurozone stability. These are important matters. But the ECB consists of unelected officials with a mandate based on inflation. It should act in the area it controls.

One of Mr Draghi’s signal achievements has been to demonstrate that the ECB is indeed Europe’s central bank, and that its decisions are not subject to any one country’s or regional central bank’s veto. The ECB reportedly started the latest covered bond buying programme without the vote of the Bundesbank. It may do the same if it starts sovereign QE.

Mr Draghi’s July 2012 pledge to do “whatever it takes” to prevent a rolling eurozone sovereign debt crisis worked without the ECB having to do much other than make clear that it will act in the interests of the eurozone as a whole. We expect continued eurozone stability in the next 12 months and see peripherals, notably the liquid Spanish and Italian markets, as offering an attractive source of credit risk. But sustainable debt dynamics in the medium term will require healthy nominal GDP growth.

Returning to the initial thought experiment, ask yourself: what do you expect for Japanese inflation seven years forward? Even with the Bank of Japan’s clear resolve in recent years – and recent huge increase in its QE programme – it is not at all clear. Years of neglect allowed a deflationary public mindset to become entrenched.

The eurozone is one shock away from sinking into deflation. There are real costs of acting too late.

The Author

Andrew Balls

CIO Global Fixed Income

View Profile

Latest Insights

Related

Disclosures

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517) and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The Italy branch is additionally regulated by the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Deutschland GmbH Italian Branch (Company No. 10005170963), PIMCO Deutschland GmbH Spanish Branch (N.I.F. W2765338E) and PIMCO Deutschland GmbH Swedish Branch (SCRO Reg. No. 516410-9190) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Spanish Branch and Swedish Branch are additionally supervised by the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act, the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and  203  to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008 and the Swedish Financial Supervisory Authority (Finansinspektionen) in accordance with Chapter 25 Sections 12-14 of the Swedish Securities Markets Act, respectively. The services provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia). This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Taiwan Limited is managed and operated independently. The reference number of business license of the company approved by the competent authority is (107) FSC SICE Reg. No.001. 40F., No.68, Sec. 5, Zhongxiao E. Rd., Xinyi Dist., Taipei City 110, Taiwan (R.O.C.), Tel: +886 (02) 8729-5500. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Av. Brigadeiro Faria Lima 3477, Torre A, 5° andar São Paulo, Brazil 04538-133. | No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.

All investments contain risk and may lose value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.