This week the European Central Bank (ECB) announced that it would aggressively tackle the deflationary problem that is plaguing Europe. As can be seen by the chart below Spain and Greece are already in a deflationary spiral with Italy barely positive. Europe as a whole saw inflation at the lowest level in 5 years with a reading of 0.3% so the ECB cut its Refinancing Rate to 0.05% and its Deposit Rate to -0.2% (that is not a misprint it is a negative interest rate - essentially you are charged for a deposit). They will also begin to purchase Asset Backed Securities at a rate of $14 billion a month in an effort to stave off continued deflation.
So what impact will this have on the rest of the globe and particularly the United States. First off I would be highly surprised to see US interest rates move higher. With the dearth of European capital looking for a home and the United States 10-year Treasury at 2.40% it is the best buy in town. In contrast the yield on the German Bund is 0.96%, Switzerland is 0.48%, France is 1.29%, Spain is 2.13% and Italy is 2.32%. Would you really want to take on the risk of Spanish or Italian debt over the United States? This demand for yield has driven the dollar to 52 week highs. While this strength is inevitable it will cause some issues for US exporters and this should result in a slow down in United States GDP.
Furthermore the rise in the dollar and the deflationary spiral of Europe are weighing on commodities. As most commodities are priced in USD an increase in the value of the dollar means that the price increases in Europe and other countries. Increased prices means less demand and less demand is showing up in the price of Gold, Silver and Oil, all of whom have fallen more than 10% in the last few months. While this will keep the lid on inflationary pressure in the United States there will be some worry that Europe will export deflation and for this reason I find it highly unlikely that the Federal Reserve will raise interest rates any time soon and they may even consider another round of quantitative easing.
The reason for the massive fight against deflation is that economies run on the premise of economic growth and asset appreciation. As the economy grows so the demand for goods and services increases and this results in price inflation and asset appreciation. It also results in greater profits and higher wages and with this comes wealth creation and once again more expansion and inflation and so it goes. Now if you have price contraction or deflation then consumers are not interested in buying goods and services as the price is lower tomorrow. With the reluctance of consumers to buy comes a contraction of GDP and a fall in asset values as the demand wanes. With the value of debt set and the underlying asset value declining the result is another wave of defaults, layoffs and so it goes. Under this deflationary scenario it is extremely difficult to stimulate even using negative interest rates for the simple reason that prices may be falling faster then the negative interest rate plus you can keep you money in cash removing the impact of the negative rate. With asset prices falling investment is shunned so stocks, properties and other hard assets take a beating.
For now this is predominantly a European problem but as you can see it can easily be exported and some of the effects are already showing up in the United States. These initial benefits (lower prices at the gas station and minimal inflation) create a small windfall but if this windfall does not translate into job and economic growth wallets are soon shut. So for now the United States is enjoying the reprieve of price pressure which is allowing the Federal Reserve to stay its course of cutting stimulus without the worry of interest rates rising but unless the ECB can reign in their problems we may soon be receiving another unwanted import.
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