The Great Deflation of 2015
Web Posted on : Sun, 25 Jan 2015
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The global economy has started 2015 on the wrong foot. The sharp decline in oil prices pushed the Eurozone into deflation in December 2014 and resulted in a significant slowdown in inflation in Japan, the UK and the US. More worrisome, there is growing evidence that these disinflationary pressures are affecting wages and, to a lesser extent, asset prices. This is leading global investors to further hedge against deflation by buying long-term government bonds, pushing yields down to historic lows. Going forward, unless this disinflationary spiral is stopped, the world economy is likely to enter a prolonged period of deflation, what we have coined the Great Deflation.
Ten-Year Government Bond Yields
Source: Bloomberg and QNB Group analysis
We had already warned about the dangers of deflation in a series of economic commentaries last year (see our commentaries dated 15 June 2014, 24 August 2014, 21 October 2014, 7 December 2014 and 21 December 2014).
Now, the reality of global deflation is upon us. The Eurozone slipped into negative inflation in December 2014 (-0.2%) on lower energy prices. At the same time, the UK registered the lowest inflation rate (0.5%) since 2000, while US inflation slowed to 0.8%, the steepest monthly slowdown in six years. Japan’s inflation was barely positive (0.7%) in November 2014, excluding the one-off effects of the consumption tax hike in April. Going forward, the expectation is that the Eurozone will remain in deflation for the whole of 2015, despite the expanded Quantitative Easing adopted by the European Central Bank last Thursday. Japan is projected to fall back into deflation as lower energy prices feed into other consumer prices. The expectation is also that both the UK and the US will experience negative inflation for at least a portion of 2015. This would imply that more than half of the global economy will be in deflation in 2015.
A more worrisome development is that these global disinflationary dynamics are starting to impact the wage setting behaviour across the globe. In the US, average hourly earnings declined 0.2% month-on-month in December. Across the Atlantic in the UK, they similarly declined 0.1% month-on-month in November. Eurozone data on average hourly earnings is only available on a quarterly basis with a significant lag, but the latest available data show a moderate increase (1.2%) in Q2 2014. Japanese average hourly wages were barely growing in November 2014. This weakness in wage growth suggests that expectations about future deflation are already affecting wage setting behaviour. If this becomes entrenched, the positive effects of lower oil prices on consumption will be offset by reduced expectations of future income, thus putting further negative pressure on an already weak aggregate demand. The impact on growth from lower oil prices would therefore ultimately be negative.
There is also growing evidence that disinflationary pressures are hitting asset prices. The latest available data show that house prices are falling in China, the Eurozone, Japan and Singapore and they are significantly slowing down in the UK and the US. Going forward, house prices are likely to decline further as deflation and lower wage growth set in. In London, for example, estate agents expect house prices to drop by up to 5%, according to the UK Royal Institute of Chartered Surveyors. In addition, global equity prices have fallen by about 5% since their peak in early July 2014, according to the MSCI World Advanced and Emerging Markets Index. While this is still within the normal volatility range, it suggests that equity markets are also pricing in the impact of deflation on global growth.
In summary, deflation is starting to spread into lower global consumer prices, depressed wages and, to a lesser extent, softer asset prices. Unless governments around the world prop up aggregate demand through an appropriate fiscal response, this disinflationary dynamics is likely to continue in 2015 and possibly beyond.