Consumer prices in the euro area declined 0.2% in December

Christian Henning Schulz, Senior economist at Berenberg Bank, on EU deflation

Consumer prices in the euro area declined 0.2% in December for the first time since the year of 2009. In addition, the slide in oil prices is adding to the deflationary pull, which is worsening the expectations for 2015. However, the Euro zone currency is also facing a noticeable slump in its value, losing more than 12% over the year. Do you think households will notice the price cut? How do you think the current market situation may influence their willingness to spend?

First of all, the sharp drop in the oil price and the current fall in the Euro exchange rates combine for a strong stimulus program for the Euro-zone economy, but they work in different ways. The decline in the oil prices helps consumers at the petrol stations as they are spending a lot less than only six months ago, which immediately improves the purchasing power. Thus, consumers may spend more on things that they desire, which, on the other hand, will boost retail volumes. Therefore, this is positive for consumption and, ultimately, GDP.

However, the lower Euro goes against that, as it makes imported goods more expensive, which is bad for the Euro zone households. Of course, lower Euro exchange rates make manufacturers more competitive and boost exports together with investment. Yet, I do not believe in deflation in the sense that households and companies will postpone purchases or investments due to the expectations of falling prices.

In Q4 of 2014 Mario Draghi puts US-like quantitative easing style policies, as a highlight of the ECB discussions. However, such bond-buying program like those that revived the U.S. has also had dangerous side effects. What consequences do you foresee from the ECB’s Quantitative Easing?

The outcome depends on how strong the program is. The markets are already pricing it in, and the bold yields have come down to a large degree. In addition to that, the decline in the Euro exchange rate is also an anticipation of the ECB doing more. Thus, if the ECB is due to disappoint and not announce the additional purchases, these developments could be reversed and could be negative for the economy. If the ECB goes beyond what markets are currently anticipating, that could be additional positive impact for the economy, which is highly desirable.

As a matter of fact, the QE only works if it makes asset prices rise in real and not nominal terms. Regarding the possible risks, I see relatively small if any evidence that QE in the UK or US caused any valuation bubble that could burst and cause financial stability risks. Bond yield may be very low, but borrowing or credit has not expanded in any major way either in the UK or US. Their house prices are not overvalued either. I do not see any risks coming from QE.

According to the ING Groep NV, one of the most bearish houses on the EUR/USD pair, the Euro zone currency is expected to weaken to $1, a level last seen in 2002. However, the median Bloomberg survey summary estimate is $1.15. What is your forecast for EUR/USD for the Q1 of 2015?

In a very short-term we expect the Euro to stay weak, but not necessarily much weaker than it is already. It is a case of „buy the rumor, sell the fact”, since the markets are speculating that the ECB will do QE. In anticipation of that, they are selling euros; however, once the ECB delivers, the rumor will be gone and the movement could be reversed. In fact, the history of what the UK or US have done shows that the QE, in case of it being successful and if it boosts the economic growth, is actually positive for the exchange rate. Thus, we expect the Euro to increase gradually over the course of the year.

How about EUR/JPY and EUR/GBP for the same period?

We expect the Euro to recover a bit against the Sterling and the Yen, as well over the course of the year, keeping in mind exactly the same reasons as for the Dollar.