Low Inflation a Sign of the Weakness of the European Economic Recovery
The EU statistics agency Eurostat said consumer prices rose 1% in January compared with a year ago, and 0.9% in February. This slowdown in inflation supports European Central Bank President Jean-Claude Trichet's view that inflationary pressures will be subdued for some time. In addition, The ZEW think-tank's economic-expectations index for Germany declined for the sixth straight month, down to 44.5 points in March from 45.1 points in February. This was still higher than economists' average forecast of 43.0 points, and well above the historical average of 27.2 points for the index. Wolfgang Franz, the President of ZEW, said, "German business activity has moved from the intensive care unit to rehab. But it is still far from full recovery."
Falling Expectations of Inflation Among Chinese Consumers Eases Pressure on Prices
The results of a survey of Chinese households released last Tuesday's (March 16) by the People's Bank of China showed consumers' future price expectations falling to a seasonally adjusted 65.6 in the first quarter, down from 73.4 in the fourth quarter of 2007. Actual inflation rates have been rising (Chinese Consumer Price Index was up 2.7% in February, from a year ago) so this is an issue leaders are paying attention to. Policymakers in China worry about expectations of future inflation because they can be self-fulfilling. If people believe prices will rise, they buy ahead, creating a surge in demand that pushes prices further up. Rapid price increases can then lead to panic buying, hoarding, and social unrest. The importance of the Chinese people's inflation expectations was reflected in Premier Wen Jiabao comments during a press conference on Sunday (March 14th) when he said, "In China's economy this year, we have to deal with three interconnected issues: maintaining stable and rapid growth, structural adjustment and managing inflation expectations. Only in this way can we avoid a double dip recession."
Modest Inflation Helps Central Banks Maintain Low Interest Rates
Inflation has remained low in the U.S. and has slowed elsewhere too, such as in Thailand and the Philippines, providing some momentum to stock markets and giving central banks the breathing room to maintain low interest rates and try to provide some tailwind for the rather tepid recovery. Thankfully, fear of an inflationary spiral remains low even since last year.
Figure 1 - U.S. Inflation Rates: 1990-2010
IMF Urges Higher Interest Rate -- Unlikely to Be Embraced by Developed Economies
Last month the IMF's chief economist published a position paper (CFO Innovation wrote a good summary), encouraging central banks and governments to raise inflation targets and arguing that low inflation limits the power of monetary policy to stimulate the economy. This is because low inflation rates establish an effective floor for the real, inflation-adjusted interest rate that central banks can generate. A negative real interest speeds recovery, but nominal rates can't fall below zero, so therefore a central bank can only create negative real rates at the current rate of inflation. For example, a -3% real interest rate can only be achieve if the nominal interest rate is zero and inflation is at least 3%. Developed economies are unlikely to embrace the IMF's suggestion to implement policies encouraging higher inflation, but some developing economies might.
Impact of Low Inflation on Businesses
For businesses, the low inflation rate is a double-edged sword. While it helps keep their cost of labor and materials low, it also maintains significant pressure on the price they can charge. As long as the economy remains sluggish and job outlooks weak, many consumers will continue to look for bargains, keeping consumer prices down. If commodity prices rise, that will put a real squeeze on many companies already struggling with thin margins.
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