Indebtedness and deflation do not go well together.
I spoke about this issue a few weeks ago (see here in French) and Paul Krugman made a post on his blog this week-end (see here). Lars Svensson, speaking on Sweden, has interesting arguments on this issue. They can change our view on ECB strategy.
Indebtedness and deflation
The issue is quite simple: when there is deflation, the real value of indebtedness increases, leading to new arbitrages in households’ budget.
The higher the indebtedness, the stronger are the impact and the arbitrages. Moreover, deflation periods are usually associated with low or negative wages growth. In other words, in this context, households have to reduce their expenditures in goods and services in order to fulfill their financial liabilities.
The macroeconomic impact is related to the high propensity to consume from households compared to a lower propensity to spend from financial institutions. Reduced consumers’ expenditures can then have a negative and persistent impact on demand and on economic activity.
This relationship between indebtedness and low inflation was at the center of the chart I proposed in my post mentioned above.
In recent articles on his blog (read here and here) Lars Svensson is wondering on the effects of deflation on the economic activity in Sweden. In March 2014, the Swedish inflation rate was negative at -0.65% and at -0.35% according to the European Harmonized Index.
Svensson says that due to households’ debt, this situation has a negative impact on economic activity.
His starting point is the following: consumers’ surveys in Sweden show that expected inflation rate is on average close to the central bank target which is at 2%. This situation is stable over time. (See first chart here)
This means that when a new credit is made, there is an implicit inflation rate at 2% for a foreseeable future. The household has made a link between his income, his credit and the future inflation rate.
In a period of very low inflation rate, the depreciation of the credit is lower than expected and its observed real value is higher than the expected real value. This gap between the two values will have an impact on consumers’ behavior.
Svensson has made a simple calculus in the case of Sweden. He starts with a loan of 1 million Swedish krona in November 2011. He then compares the real value of this loan with an inflation rate at 2% and with the observed inflation rate at 0% in Sweden from November 2011 to November 2013. The gap is 40 000 krona. In other words the real value of the credit was expected to be 40 000 krona lower. (see the 3rd chart here)
What Svensson says is the following: the higher real loan value has an impact on consumers’ behavior. In other words, if the inflation rate is lower than the target for an extended period, then this will create arbitrages and changes in the structure of expenditures. The impact on demand can then be negative and persistent.
The interesting point is that this analysis is on Sweden. Deflation risk is high even in a country that doesn’t belong to the Euro Area. Deflation is not a specific characteristic of the Euro Area. This latter can has deflation as a consequence of its adjustment mode but the explanation can be larger.
For Svensson the main reason for deflation in Sweden is monetary policy. The central bank has thought, in summer 2010, that the economy was strong enough to support higher interest rates. This was clearly not the case. At the Riksbank, there were strong discussions between the monetary policy committee and Svensson who was then deputy governor. He explained that it was too early to increase interest rates as the economy was still fragile. He left in May 2013. That’s something we should keep in mind when we imagine that central banks have to increase interest rates rapidly when there is a stronger momentum. At the same time we cannot avoid to thinking at the two useless and probably counter-productive increases in interest rates by the ECB in April and July 2011.
Following Svensson we have to keep in mind that a below-target trajectory for the inflation rate can harm the economy and have a negative impact on the economic activity. Svensson points out that it is not necessary to be in deflation to have this situation. In countries with high private indebtedness and deflation, the negative effect can be persistent, limiting the possibility of a recovery.
A below-target trajectory of the inflation rate can then be a drag to recovery. When we think at ECB’s forecasts on the inflation rate we can imagine that we are in this situation. The ECB does not expect that the Euro Area inflation rate will converge to 2% before 2017-2020. In 2016 a 1.5% inflation rate is expected. Following Svensson, this situation will weaken the recovery even if the whole Euro Area is not in deflation.
This means that the ECB has to act rapidly even if it does not anticipate a deflation.