Thursday, October 16, 2014

Is deflation really such a big deal? | Euro dollar prospects

We have written before about the perceived threats of deflation and why it is feared by central bankers and others. The worry is that in a time of falling prices people will defer purchases in order to benefit from yet lower prices in the future. The idea is that this threatens consumer spending and the beneficial effects it has on economic growth.

However, there are always many sides to any story and I am grateful to Paul Hannon and his colleagues of the Wall Street Journal for the following insights on the issue. Hannon writes:

“Consider the kinds of purchases you would delay if you expected prices to fall in coming months. Not food, because you have to eat, or energy, because you have to heat or cool your home. But you might think about delaying the purchase of a new car–it’s a big expense, and you may not absolutely have to have the latest model right away”.

But, as he also points out, auto sales in the US are actually increasing. The same is true of Europe (see above). So this expense is not being postponed. Intuitively, it can be assumed that such things as vacations will also be indulged in, because life is too short to be putting them off. The housing market is a law unto itself and, in any event, mortgage payments apart, does not figure in the official inflation statistics.

Then there are the components of inflation to be considered. We have shown the chart below previously, which indicates that the main driver of low inflation is the energy factor. This is hardly surprising given the drop in the price of oil that has been underway for some time, and which is set to continue. Low energy prices are actually a boon to most economies.

Euro - dollar prospects

One thing that deflation, or the threat of it, does achieve, is it provides an incentive for monetary easing. Put simply, low inflation gives central banks like the US Federal Reserve the ability to maintain low interest rates for longer, which they are minded to do anyway in light of the worries that still exist in regard to possible slack in the US economy.

This, in turn, provides us with a bias towards a weaker US dollar. Already, what might just turn out to be a substantial retrace in the EURUSD exchange rate might be coming into being for this very reason. The chart above shows a series of higher highs and higher lows on the recent four hour chart. These always indicate a rising trend. How long this one will last is another question, but the matter of the effects of low inflation must be taken into account.

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