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Jim Leaviss: How the extraordinary may become the inescapable

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The recent strike by Lufthansa pilots, some of the highest wage earners in Germany, may have elicited little support from their fellow countrymen but is emblematic of the wider problems that continue to face the eurozone.

The strike was just the latest in a series of wage-related demands that has seen various trade unions win big pay hikes for their members for 2014-2015. It came hot on the heels of German Chancellor Angela Merkel’s decision to approve the introduction of the country’s first minimum wage after agreeing the change late last year as part of post-election coalition negotiations.

Such a move should stimulate wage growth after a decade of relative stagnation, giving further support to an already buoyant economy. The German government expects GDP growth of 1.8 per cent this year and 2 per cent in 2015 following a more sluggish 2013 that was flattered by a fourth-quarter surge of 0.4 per cent. 

Three member states in deflation

This is in sharp contrast to much of Europe’s periphery, where such numbers are the stuff of dreams and the prospect of deflation looms increasingly large. Eurozone inflation is now just 0.5 per cent and falling. And this already low figure masks the even starker fact that three of the bloc’s member states are now in deflation after preliminary Spanish CPI came in at an annual rate of -0.2 per cent in March. For the record, the other two offenders are Portugal (since February) and Greece (since early 2013).

Meanwhile, the European Central Bank’s balance sheet has been shrinking over the last two years as eurozone banks repay the emergency loans made to them at the height of the financial crisis. 

This had been gathering pace in recent months as banks tried to get their houses in order ahead of the ECB’s Asset Quality Review due later this year.

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This is not all bad as it points to a healthier outlook for the region’s biggest banks. But it also means that there is less liquidity than ever sloshing around the banking sector, with a resultant fall in lending that threatens to undermine any green shoots of recovery.

The ECB’s experience is directly opposite to those of the US Federal Reserve and the Bank of England, both of whose balance sheets have been swelled – some might say bloated – by continued monetary stimulus. Let’s not forget that while the Fed continues its strategy of gradual tapering, it is still currently pumping $55bn into markets each month.

Eurozone interest rates stand at just 0.25 per cent, not dissimilar from the historic lows in many developed economies but with a weaker outlook for growth and more deflationary pressure than either
the US or the UK. As Japan’s “lost” 20 years bear witness, the zero bound is a dangerous place to be. It has only been since Shinzo Abe’s election in 2012 and the introduction of his three arrows of fiscal stimulus, monetary easing and structural reforms that Japan has shown any credible signs of emerging from the economic quagmire in which it has been trapped for so long.

Of course, the prospect of deflation is not something that Europe’s central bankers are facing in isolation. UK CPI inflation fell last month to a four-year low of 1.7 per cent while in the US, the PCE deflator index – one of the Fed’s preferred inflation measures – dipped to 0.9 per cent, its lowest level since October last year. US inflation has now run below the Fed’s target for 22 straight months.

Should this continue unchecked, Fed officials will have plenty to think about later in the year as they move out of their tapering phase and towards eventual rate hikes.

Range of extraordinary tools

ECB officials may remain committed to the line that deflation risks are not imminent but it is clear that chairman Mario Draghi and fellow members of the Bank’s Governing Council are finally getting serious in exploring a range of extraordinary tools to help stimulate recovery, including QE.

The ECB has to date spectacularly failed to follow the quick and aggressive example set by the Fed and BOE. Both these central banks are now edging closer to the point where they can finally raise rates and, in so doing, give themselves the luxury of having both a brake as well as an accelerator when setting policy.

If it wants to enjoy similar options in due course, the ECB needs to act decisively and in extraordinary fashion to head off deflation and generate sustainable economic growth.

Jim Leaviss is head of retail fixed interest at M&G Investments

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