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Tuesday, March 31, 2009

Unmployment Rises In Germany

German unemployment rose once more in March as both foreign and domestic demand weakened, leading companies to face growing pressure to make layoffs. The number of people out of work rose by a seasonally adjusted 69,000 to 3.4 million. The adjusted jobless rate rose to 8.1 percent from 8 percent in February. Germany’s ILO compatible jobless rate rose to 7.4% in February from 7.3 percent in January.

German unemployment began to increase in November after falling steadily for more than three years. The jobless total may increase by an unadjusted 430,000 to 3.7 million this year, the Labor Agency’s IAB forecasting unit said on March 24. The projection assumes an economic contraction of 3.5 percent. The final number may be even higher, according to the agency’s President Frank-Juergen Weise, who said in an interview that he won’t exclude the unadjusted total rising to 4 million by the end of the year.

The labor provisions allow companies to reduce workers’ hours and pay while keeping them on payrolls and the labor agency tops up pay packets. In January the programme was extended to 18 months from six months for each individual worker, and last week Angela Merkel's Christian Democratic Union of chancellor Angela Merkel proposed the government extend the maximum duration of the short-shift scheme from 18 to 24 months. In February alone, 17,000 companies applied for the scheme for 700,000 workers.

At the same time the number of persons employed in the German economy seems to have peaked and in Fenuary the total was 39.81 million, an increase of just 31,000 persons or 0.1% on February 2008. Hence, the employment increases registered in the first half of last year have now more or less been cancelled out by the monthly decreases that have been seen since November, and we now begin to enter decrease territory.

Compared with January, the number of persons in employment was down by 14,000. That decrease, which seems moderate considering the economic crisis, is perhaps better put into perspective when taking into account the average trend of employment figures in any February of the last ten years.

A negative employment trend is also revealed when you strip out typical seasonal variations. Compared with the previous month, the seasonally adjusted result decreased by 13,000 to 40.20 million persons in employment in February 2009.

The Contraction In German Services Slows Slightly

The German services purchasing managers index edged up in March after falling to a record low in February. However, with the PMI still only marginally higher than February's level, activity in the services sector continued to fall at sharp rate in the month, according to Markit Economics.

The German services PMI increased to 42.3 in March, up from both the advance estimate of 41.7 and February's 41.3 level, Markit reported on Friday.

According to the PMI survey respondents, general demand in the services sector remained at weak levels, as reflected in new business falling for the seventh consecutive month. New orders also continued to lose ground in March.

Excess capacity and a lack of new work allowed firms to further reduce their work backlogs and forced them to cut their workforce levels for the second month in a row. "However, the rate of job shedding was only modest, easing on the pace seen in the previous month" Markit noted.

Monday, March 30, 2009

German Retail Sales Decline Again In March

The Bloomberg Euro-Zone Retail Purchasing Managers' Index - based on a mid-month survey of more than 1,000 executives in the euro area retail sector - rose marginally in March - to 44.1, up from 42.3 in February to 44.1 in March. This was the smallest monthly drop in the value of sales in five months, but it was still a drop, and quite a significant one, since the neutral point between contraction and expansion is 50. Still first quarter retail sales have seen an average monthly decline which is smaller than in the fourth quarter of last year (an effect of all those stimulus programmes), however sales have now fallen for ten consecutive months.

The German Sales Contraction Accelerates

Retail sales in Germany, the zone's largest economy, dropped for a 10th month in March as unemployment rose and manufacturing industry continued to grapple with a slump in export orders. The retail PMI dropped to 44.4 from 45.4 in February.

German households are cutting spending as a deepening economic slump forces companies to eliminate jobs, pushing up unemployment. The fall comes despite the decision of German Chancellor Angela Merkel to spend about 82 billion euros in measures to stimulate growth, including tax breaks and incentives to buy new cars.

“Consumers were generally unwilling to spend, while evidence of shorter working hours at local companies reportedly curtailed their buying power,” Markit said in the statement. “The overall decline may have been greater were it not for government incentives to scrap old motor vehicles, which continued to support sales in the automobile sector.”

The Italian Sales Contraction Enters Its 25th Month

Italian retail sales contracted for a 25th month in March as the country's worst recession in more than 30 years prompts companies to cut jobs, in the process eating away at consumer demand. The index was up slightly at 41.9, from 38.2 in February.

Italy slipped into its fourth recession since 2001 last year, sending the unemployment rate to a two-year high. The government has adopted around 40 billion euros in stimulus measures, but is constrained from spending more due to the high level of prior government debt. As a result the OECD forecast the economy will likely contract by 4.2 percent this year.

French Sales Hold Up A Little Better

France also saw a moderation in the rate of sales decline, with the pace easing from February's record but remaining steep. Month-on-month the index rose from 42.6 to 45.7, rounding off a first quarter that has seen the weakest sales performance in the history of the French survey. French retailers have reported falling sales in five of the past six months.


According to provisional results of the Federal Statistical Office, retail sales in Germany decreased by 5.3% in nominal terms and vy 5.3% in real terms in February 2009, when compared with the corresponding month in the previous year. When adjusted for calendar and seasonal variations, the February turnover was in nominal terms 0.2% larger and in real terms 0.2% smaller than that of the preceding month.

Thursday, March 26, 2009

German Consumer Confidence Falls In March

German consumer confidence declined for the first time in seven months as workers worried about keeping their jobs amid the worst recession since World War II. GfK AG’s confidence index for April, based on a survey of about 2,000 people, declined to 2.4, the Nuremberg-based market- research company said in a statement today. March’s result was revised down to 2.5 from 2.6.

Economic expectations: slight decline

After an increase in February, economic expectations in March this year have decreased by 4.9 points, a drop that is almost on a par with the gains of the previous month. The indicator currently stands at -32.8 points.

At present, consumers are still seeing little reason to abandon their pessimism as regards the economy, and fear of job losses is also coming increasingly to the fore. For the time being, this is still overshadowing the positive effect of the Economic Stimulus Package II on the domestic economy.

Income expectations: minimal losses

After the extremely positive development in income expectations, which rose by almost 10 points in February, the indicator remains virtually stable for March. Income expectations have decreased only minimally by 0.4 points, to currently stand at -11.4 points.

The continuing low rate of inflation is having a positive effect here, and falling food prices and low energy prices are also strengthening consumer purchasing power. Even discount retailers are currently engaged in price wars, enticing consumers with offers and sales. The pension increase agreed by legislators for summer 2009 was only made public after the survey had been completed, and therefore did not affect the results. However, this boost for pensioners is likely to have a stabilizing effect on income expectations in the future.

Propensity to buy: plateauing at a good level

Propensity to buy is at a positive level. The indicator has almost completely maintained its very good level in March this year, recording only comparatively modest losses of 0.7 points. Currently, propensity to buy stands at 13.9 points, which is still 24 points above the level recorded at the same time in the previous year.

The low rate of inflation is still probably one of the most important reasons why the propensity to buy of German consumers is plateauing at this very good level. Financial incentives, which the government is creating with its Economic Stimulus Package II and the retail trade is supplementing with its own promotions, are also having an effect. For example, many car manufacturers are creating buying incentives by offering further concessions to complement the government’s bonus for scrapping old cars. In addition, many retailers from the consumer electronics and household appliances sectors are copying the principle of the car scrapping bonus and applying it to their own products.

Wednesday, March 25, 2009

IFO Business Confidence Index Falls Again

German business confidence fell to the lowest level in more than 26 years in March. The Ifo institute in Munich said its business climate index, based on a survey of 7,000 executives, dropped to 82.1 from 82.6 in February. That’s the worst reading since November 1982.

Tuesday, March 17, 2009

ZEW Investor Confidence Imroves In March

German investor confidence unexpectedly rose to the highest level in almost two years in March after the European Central Bank reduced borrowing costs to a record low. The ZEW Center for European Economic Research in Mannheim said its index of investor and analyst expectations increased to minus 3.5 from minus 5.8 in February. That’s the highest reading since July 2007.

Wednesday, March 11, 2009

Germany's Recession Worsens Again

Well sometimes it never rains but it pours, and as far as Germany is concerned, economically speaking (and my condolences to each and every German for yesterday's tragedy) more than a "rainy season" what we seem to have is a monsoon, with a torrential downpour one day after the next. The lastest piece of bad news comes on the export front, with German exports dropping for a fourth consecutive month in January, as what is still Europe’s largest economy fell ever deeper into what is now its worst recession in 60 years. Working day and seasonally adjusted sales abroad fell 4.4 percent from December (when they dropped 4 percent). According to provisional data from the Federal Statistical Office, Germany exported goods to the value of EUR 66.6 billion and imported commodities to the value of EUR 58.1 billion in January 2009. Exports were thus 20.7% down in January when compared with January 2008, and imports were 12.9% down.

Germany had a foreign trade balance surplus of EUR 8.5 billion in January compared to EUR 17.3 billion in January 2008. According to provisional data from the Deutsche Bundesbank, the current account surplus was EUR 4.2 billion in January 2009, which included a services deficit of EUR1.5 billion, a factor income surplus of EUR 2.8 billion), a deficit on current transfers of EUR 4.3 billion). This was just a little over half the January 2008 current account surplus of EUR 15.6 billion.

Compared with January 2008, exports to EU countries decreased by 18.7%. A larger fall (–21.4%) was registered in exports to EU countries not belonging to the euro area.

The Fall In Exports Pulls Down German Industry With It

German industrial production plummeted by a dramatic 7.5 per cent in January, according to the latest data from the Economics and Technology Ministry, showing just how the global recession, and in particular the trauma which is shaking Eastern Europe's economies to their foundations, has tightened its grip on Germany. The seasonally adjusted fall in production was far worse than the 3-per-cent drop that analysts had forecast and suggests that all of this is now cutting very deep.

While Orders Slump

Meanwhile German manufacturing orders collapsed even further in January, plunging 38 percent from January 2008, the biggest drop since data for a reunified Germany started in 1991, according to the Economy Ministry. From December they fell 8 percent. Export factory orders were down 11.4 percent in January from December, with orders from outside the 16-nation euro region dropping 18.2 percent. Domestic demand dropped 4.3 percent in the month.

“The annual slump is absolutely catastrophic,” said Alexander Koch, an economist
at UniCredit MIB in Munich. “The extent of declines is terrifying.”

German plant and machinery orders from abroad plunged 47 percent in January from a year earlier, the biggest drop since data were first compiled in 1958, according to the VDMA machine makers association.

And February's PMI Data Only Gets Worse

And the bad news shows no sign of slowing up, since the Germany private sector shrank in February at the fastest rate in more than a decade according to the latest Composite Purchasing Managers reading. Final data from Markit economics showed the composite PMI fell to 36.3 from 38.0 in January, the lowest level registered since the series began in January 1998. The composite PMI reflects the results of services and manufacturing sector surveys.

"The German economy remained on a sharp downward trajectory in February as a result of rapidly falling manufacturing output and a marked downshift in the performance of the service sector," said Tim Moore, economist at Markit Economics.

The data were consistent with the German economy contracting by some 3 percent this year according to Markit estimates.The German government expects the economy to contract by around 2.25 percent this year, though some economists have suggested we may see a 5% contraction, and this is more or less the view I hold from what we have seen to date. Since World War Two, the German economy has never contracted by more than one percent in any one year.

The PMI for the manufacturing sector posted 32.1 in February, up from January's 32. Although the change was slight it is the first time the index has risen since March 2008, and may suggest that at least the rate of contraction may now not worsen.

Anecdotal evidence from the PMI survey suggested the decline in private sector activity reflected a reluctance among clients to commit to new work. A sub-index on new business fell to 31.7 from 35.2 in January, hitting a series low.

At the same time the final services sector PMI fell to 41.3 from 45.2 in January, hitting yet another series low.

Falling Retail Sales

Unsurprisingly German consumption has been falling.

Retail sales in Germany fell in January, falling on a seasonally adjusted basis by 0.6 percent from December. From a year earlier, retail sales declined 1.3 percent. Sales of food, tobacco and beverages declined 2.4 percent from a year earlier and households reduced spending on clothes and shoes by 1.5 percent. And although the Bloomberg Retail Purchasing Managers Survey showed an improvement in sales over the January reading - the German month-on-month index rose from 41.7 to a four-month high of 45.4 - they are still dropping. In fact the indicator has now shown German sales falling for nine successive months.

At the same time if we look at the seasonally adjusted retail sales index compiled by the Federal Statistics Office we will see that it has been declining even longer than the nine months registered by the PMI, since December 2006, in fact, and it is pretty plain to even the naked eye to see that sales never recovered from that "harmless" VAT rise - you know, the one which was supposed to have been hardly noticed.

Export Driven Economy?

The connection between expòrt growth and GDP growth in Germany is now pretty clear I think. Gross domestic product fell a seasonally adjusted 2.1 percent in Q4 2008, while exports were down 7.3 percent quarter on quarter. That’s the third consecutive quarterly drop in GDP and the biggest single quarterly fall since the first three months of 1987.

The main reason for the decline of the German economic performance is obviously the drop in net exports, i.e. the balance between exports and imports of goods and services. Price adjusted exports were down exports 7.3% while imports dropped 3.6%, so that the balance between exports and imports contributed minus 2.0 percentage points to the GDP decline.

German companies reduced investment in machinery and equipment in Q4, spending 4.9% less than in the third quarter. Previously gross fixed capital formation in machinery and equipment had risen for eight consecutive quarters. Capital formation in construction wasdown by 1.3% lower in the fourth quarter than a quarter earlier, and final household consumption expenditure fell by 0.1%. Most significantly, companies considerably increased their inventories between October and December, with the inventory build-up contributing a positive 0.5 percentage points to growth. If we put this 0.5 pp together with the 1 percentage point contributed in Q3 it is clear that there is a large unwind going to happen at some point. Basically you can subsidise output and jobs, but if there are no end consumers one link in the chain is missing.

As can be seen in the chart, and despite all that tostesterone driven "recoupling" bunk, household spending has been flat since the VAT hike, even in Germany's most sustained period of growth and job creation since the mid 1990s.

Unemployment On The Rise

German unemployment rose again in February although the new government job protection measures seemed, as the increase was less than might have been expected - in fact the jobless total increased by 40,000 (to 3.31 million), on a seasonally adjusted basis, pushing the seasonally adjusted unemployment rate from 7.8 per cent to 7.9 per cent, suggesting there has been a significant deterioration in labour market conditions since December.

On the other hand employment creation is slowing, and the number of persons in employment was 39.83 million in January, falling below the 40 million threshold for the first time since March 2008. In January 2009, employment was up on January 2008 by 107 000 persons or 0.3%. However employment dropped markedly from the previous month. Compared with December 2008, 1.7% or 704 000 less persons were employed. Typically, there is a significant decline in the number of persons in employment in the month of January. In both 2007 and 2008, ie during the full strength of the economic upswing, the number of persons in employment dropped by nearly half a million each year. However, as reported by the Federal Statistics Office the decline was rather stronger this year than in the two previous years.

On a seasonally adjusted basis the number of persons in employment amounted to 40.21 million in January 2009. Compared with the preceding month of December, that was a seasonally adjusted decline of 84 000.

In addition it has to be remembered that a significant number of people are being maintained in employment by the government support programme. Struggling businesses can apply to shorten working hours in exchange for government wage and social-insurance subsidies for a period of up to 18 months, compared to just six months in the past. Since October business have applied to cut the hours of some 775,000 workers, with more than 290,000 applications falling in January alone.

Under the arrangements, the Federal Employment Agency (BA) pays 60% (or 67% for employees with children) of the flat-rate calculation of the missing net pay for each eligible employee. Employers continue to pay their employees but will are reimbursed by the BA. If, for instance, the hours worked in a company are reduced by half, the employee receives only half of his/her normal pay. The BA then pays the employee 60% of the other half of his/her wage or salary. Thanks to substantially reduced wage costs, companies can usually manage without lay-offs, which benefits both sides, with the only proviso, as I say, that you still need to find someone to buy all those products (remember the rapidly accumulating inventories).

Companies announced last month that they’re planning to add a further 600,000 workers to those already working shortened shifts, according to Labor Agency head Frank-Juergen Weise.The share of German companies planning to cut jobs rose to 30 percent in January from 18 percent in October, according to a survey of 25,000 companies carried out by the DIHK chambers of trade and industry.

While Wages Have Been Rising

At the same time hourly labor costs in Germany’s manufacturing and service industries rose the most on record in the fourth quarter of last year, even as companies cut output and introduced shorter working hours. The cost of an hour’s work increased 3.9 percent in the fourth quarter from a year earlier, according to the Federal Statistics Office. That’s the biggest gain since the data was first compiled in 1997. Seasonally and working day adjusted hourly costs rose 1.7 percent from the third quarter.

Gross wages and salaries among manufacturing and service companies increased 4.1 percent from a year earlier after gaining 2.4 percent in the third quarter. Non-wage costs rose 3.1 percent in the fourth quarter from a year earlier after gaining 1.7 percent in the third quarter.

Despite - or perhaps becuase of - all that added employment, overall labour productivity (price-adjusted gross domestic product per person in employment) decreased by 2.6% in Q4 2008 over a year earlier. While measured per hour worked, labour productivity fell by 1.3%, the number is lower because the number of hours worked per persons in employment dropped by 1.2%.

Fiscal Prudence To Come?

Germany's government has come under some criticism for failing to introduce a hefty enough stimulus programme. Angela Merkel’s government is trying to soften the impact of the recession by spending about 80 billion euros over two years to support the economy, with measures which include investment in schools and roads, lower health- insurance payments, tax breaks and incentives to buy new cars. The efforts amount to about 1.5 percent of gross domestic product, according to the IMF, which has called for stimulus of at least 2 percent of GDP from all countries.

However at the same time as the German government is under pressure from the IMF (and US Treasury secretary Timothy Geithner, who has called the IMF proposal "a reasonable benchmark") to move in one direction, it is coming under pressure from th EU Commissioon to think about moving in the other, and Germany's next government may well need to start to cut spending as early as 2011 in order to start to move towards a balanced budget, according to European Union finance ministers meeting held in Brussels this week.

After conducting “expansionary” fiscal policy this year and next to combat its deepest recession since World War II, Germany should “reverse the fiscal stimulus in order to support significant budgetary consolidation,” the EU finance ministers said in response to budget plans presented by Germany. The German government forecasts the German budget, which was almost balanced last year, will show a deficit of 3 percent of GDP in 2009 and 4 percent one next year. The ministers said that, in order to reduce new borrowing, the new government which is formed after the September 27 elections should implement a planned budget rule for the both federal level and the nation’s 16 states with the objective of bringing the combined budget close to balance.

Thus German Finance Minister Peer Steinbrueck said categorically this week that the government is “not discussing any additional measures” to support the economy, highlighting his concern that public finances may become unsustainable.

On the other hand, concern for the evolution of the German economy in the near term is mounting, and Bundesbank President Axel Weber stated earlier this week that the global economy is “mired in a sharp slowdown.” and as a consequence Germany, which is the world’s biggest exporter, “is particularly badly affected because of declining export demand.”

Finally the forecasts are steadily getting re-written downwards, and the IfW Institute have revised their earlier outlook for a 2.7 percent contraction to a 3.7 percent one. Germany’s worst post- war performance to date had been a 0.9 percent contraction in 1975. Sign of the times, sign of the times.

Wednesday, March 4, 2009

The German Economy Contracts At An Ever Faster Rate

The Germany private sector shrank in February at its sharpest rate in more than a decade in February according to the latest Composite Purchasing Managers reading.
Final data from Markit economics showed the composite PMI fell to 36.3 from 38.0 in January, the lowest level registered since the series began in January 1998.

"The German economy remained on a sharp downward trajectory in February as a result of rapidly falling manufacturing output and a marked downshift in the performance of the service sector," said Tim Moore, economist at Markit Economics.
The data were consistent with the German econom contracting by some 3 percent this year, Tim Moore added.The German government expects the economy to contract by around 2.25 percent this year, though some economists have gone as suggesting we may see a 5% contraction, and this is more or less the view I hold from what we have seen to date. Since World War Two, the German economy has never contracted by more than one percent in any one year.

Anecdotal evidence from the PMI survey suggested the decline in private sector activity reflected a reluctance among clients to commit to new work. A sub-index on new business fell to 31.7 from 35.2 in January, hitting a series low. The composite PMI reflects the results of services and manufacturing sector surveys. The final services sector PMI fell to 41.3 from 45.2 in January, hitting a series low.

A services sub-index on new business dropped sharply to 36.6 from 42.5 in January.The February manufacturing PMI survey, released on Monday, showed the sector contracted for a seventh month running in February, as employers cut staff in response to sagging global demand.

Tuesday, March 3, 2009

Eurozone Inflation Expectations Fall As The Output Gap Rises

It’s a depressing spectacle: on both sides of the Atlantic, policy-makers just keep falling short — and the odds that this slump really will turn into Great Depression II keep rising.

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.

Oh, and Jean-Claude Trichet says that there is no deflation threat in Europe. What’s the weather like on his planet?
Paul Krugman, yesterday

What follows here are simply a few charts to illustrate further the argument I developed yesterday as regards the significance of the deflation threat which now exists in the eurozone. The argument is that the ECB is once again being far too cautious, and risks allowing the entire eurozone to entire a deflationary cycle which may prove to be a lot harder to get out of than it was to get into. In my view the ECB should bring the refinancing rate close to zero % at next Thursday's rate setting meeting, and then explore what measures can be taken to introduce a zonewide version of US/Japan style Quantitative Easing as quickly as possible.

The key argument I am presenting is that it is a mistake to focus at this point on what is happening to energy, food and other commodity prices. The key issue is what is happening to core prices, and what will continue to happen to them as output contracts further. The other side of the coin are inflation expectations, and as we will see below these are now falling rapidly across Europe. It is very important at this point that these expectations do not get "locked in" to price fall expectations.

It is evident that the degree of economic slack in the OECD is now widening rapdily as unemployment rises and capacity utilization falls. The OECD output gap (the difference between current levels of output and some estimate of what "capacity" output could be at this point) continues to widen and is now only second in importance to the output gap seen in the early 1980s. In fact, the output gap is likely to have widened further since the OECD last made its forecasts in November 2008 (the OECD leading indicator has, for example, continued to decline since that point) but the output gaps shown for the US, the UK and eurozone in the chart below are already sufficiently pronounced to make the point quite clearly I think.

In fact, spare capacity is a phenomenon which extends way beyond the OECD, and economies throughout the world are operating at below their potential and look set to do so for both the remainder of this year and most of 2010. Global manufacturing has been contracting and global trade has collapsed. Here is the latest JP Morgan Global Manufacturing PMI.

The IMF currently estimates that the cumulative global output loss relative to potential over the period 2008-2010 will be as much as 5% (see chart below).

And inflation expectations are falling rapidly. The latest findings in the European Commission’s own consumer questionnaire show that the net balance of respondents in the UK and the Euro zone expecting prices to be higher this time next year is now at the lowest recorded level - just 2.7% and 4.1% respectively ( see chart below).

Monday, March 2, 2009

"There Is No Deflation Threat In Europe" - Jean Claude Trichet - Oh Really!

He's at it again. Last year he was busily trying to worry us all that inflation was set to get completely out of hand among the 16 countries who make up the eurozone. Now the President of the European Central Bank, Jean-Claude Trichet, is hard at it on another tack and is busying himself trying to convince us that there is no credible deflation threat facing these countries. Apart from getting it wrong on both occasions, the common point here would be a certain inbuilt "inflation bias", a bias which was earlier called "the original sin of the Bundesbank" by nobel prize winning Italian economist Franco Modigliani.

"There is presently no threat of deflation," Trichet told a committee of the European Parliament on Wednesday 14 February. "We are currently witnessing is a process of disinflation, driven in particular by a sharp decline in commodity prices." ..."It is a welcome development," he said, adding that the fall in energy, and other prices should help boost struggling economies.
Apart from manifesting a spectacular lack of economic judgement, the Financial Times's Banker of the Year 2007 is now forcing us to ask the embarassing question as to just how far "out of touch" you can get with the material you are supposed to be handling and continue to hold down your job. It seems we are forced to come up with the rather worrying response, that, in the case of the principal EU institutions (remember the sad case of Economy and Finance Commissioner Joaquin Almunia), the answer is "bastante" (consideably), since a quick look at the data we have to hand shows us that Eurozone inflation is already significantly undershooting the European Central Bank’s own target (and principle policy objective) of maintaining the annual rate “below but close” to 2%. Worse, by all appearances the rate of consumer price inflation in the eurozone is now set to head straight off into negative territory.

If we look at headline HICP inflation on an annualised basis, we will find that it fell more than expected in January - to 1.1 per cent, according to Eurostat data - down quite dramatically from the peak of 2.7 per cent hit in March last year. This was the lowest level we have seen since July 1999, and a sharp drop from the 1.6 percent rate registered in December. On a month-to-month basis, prices were down 0.8 percent. The "core" inflation rate - that is consumer inflation without the volatile elements of food, energy, alcohol and tobacco - we find it still stood at 1.6%, since the biggest impact on headline inflation comes from the decline in food and energy costs. But if we look at the monthly movement in the core index, we find that it dropped by a very large 1.3% (see chart below).

Now if we come to look at the core inflation rate over the last six months, we find that the index has only risen 0.1% (or an annual rate of 0.2%). This gives us a much more accurate reading on where inflation actually is at this point in time, and where it is headed. The chart below shows the six month lagged annualised rate for the last twelve months, and the sharp drop in January is evident. If things continue like this, then the eurozone as a whole is headed straight into deflation, for sure.

Why Should Prices Continue to Fall?

So what are the grounds for thinking that inflation may be now heading into negative territory (ie that we are entering deflation right now), despite the fact that the ECB revised forecast is likely to come out at about 0.7 per cent this year and 1.5 per cent in 2010, according to estimates from Julian Callow, European economist at Barclays Capital. Well let's look at a chart produced by Paul Krugman showing the relation between the US output gap and the inflation rate.

Now as Krugman explains the figure plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. (Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007).

The fit, as he says, is not perfect, but the correlation is evident, and there is an implied slope of about 0.5 — that is, every percentage point by which real US GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year. Now I am not going to advance here estimates of the present output gap in the eurozone, but we do have clear indications of a sharp and ongoing contraction in demand in the GDP numbers. Eurozone GDP contracted by 0.2% between the second and the third quarters of last year, and by 1.5% between the third and fourth quarters.

What's more the key indicators suggest that the contraction is accelerating at this point. The February Markit euro-zone composite PMI reading dropped to a record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one, and considering (as mentioned previously) that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). For those of you who simply don't believe that PMIs can tell you so much, take a look at Markit's own chart (below), showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. The results they achieve are pretty impressive I would say.

and if we look at an additional indicator (the EU's own Economic Sentiment Indicator for the eurozone) we will see that it hit yet another low in February (see below) which again suggests that the contraction is accelerating at this point, and substantially so.

So the core HICP index is on the point of turning negative on a six monthly basis, and the situation appears set to get even worse, and our Central Bank President assures us that "there is presently no threat of deflation". So which world am I living in, or which is he?

There are further reasons to anticipate a sharp downward pull on prices from some countries in the zone (like Spain and Ireland), since they have housing and construction booms which are in the process of unwinding, and the only way they can recover the competitiveness they have lost is by conducting a sharp and significant downward revision in prices and wages (since in a currency union there is effectively no currency to devalue). The two charts below show the loss of competitiveness experienced by the Irish and the Spanish economies (respectively) with regards to the German economy since 1999 as measured by real effective exchange rates (REERs).

REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators are deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness.

Now the eurozone being a common currency area presents us with specific problems in the context of deflation since, as the Irish economist Philip Lane argues a member of a currency union comes up against a natural limit in national-level deflation. Thus, he argues, while a country like Ireland may well face a sustained period of inflation below the euro area average (such that it may be negative in absolute terms for a greater or lesser period of time), the situation should tend to be self-correcting since the deflation implies an improvement in competitiveness, which should generate a boost in export driven economic activity and, over time, a return to an inflation rate at around the euro area average. I'm not sure that this argument is 100% valid, since sufficient internal demand lead deflation can so effect household and corporate solvency that debt deflation can at the very least send a country off into a sizeable and significant correction (say a decade long one) before the price level falls sufficiently to generate sufficient export activity to offset the decline in domestic demand and enable balance sheets to recover. But going into all this would get pretty wonkish, so, leaving that rather theoretical point aside, lets think about a more rather concrete and immediate reason for worrying about what is happening at the present time in the eurozone, and that is the possibility that the inflation and competitiveness benchmark country, in this case Germany, may itself be about to experience an internal price deflation process which is every bit as sharp as the fall in prices which is taking place in those economies which are supposed to be correcting vis-a-vis Germany itself. That is, let's consider the possibility that through this mechanism the deflation may become eurozone wide, and relatively self perpetuating, if something is not done to break the cycle.

So, if we now go on to look at the two relevant charts below (for Spain and Ireland) we will find that in each case core indexes are falling more or less in line with the German one. In fact, both the Spanish and the German indexes are unchanged over the last six months, the Irish one is down 0.5%. At this pace (a 1% a year differential with Germany) Ireland would recover its 1999 comparative position vis-a-vis Germany in around 30 years, a rather lengthy process to say the least.

But the point here is not that prices are falling in Ireland and Spain (they have to do this) but that prices are also set to fall in Germany, and this is where monetary policy from the ECB becomes vital, since if Germany is allowed to fall into deflation then it will be extremely difficult for Spain and Ireland to "correct" (the drop in wages and prices would have to be sharp indeed) but also monetary policy from the ECB would be in danger of becoming a complete mess.

Of course not everyone on the ECB governing council shares Trichet's rosier-than-rosy view, and in a comment that offered an insight into how at least some ECB council members are thinking, Mario Draghi, Italy’s Central Bank Governor said recently that “the governing council is keeping a close watch on the real cost of money”. What he means is that, if Spain's 1.5% drop in core prices over the last three months turned into a 6% annual drop, then the real rate of interest currently being applied would be around 8%, which would constitute a very tight monetary policy in the context of Spain's worst recession in living memory.

Perhaps some readers may feel I have been unduly hard on Jean Claude Trichet in this post, but I would simply close by reminding everyone of the conclusions reached in a once widely quoted paper - Preventing deflation: lessons from Japan's experience in the 1990s, by Alan Ahearne, Joseph Gagnon, Jane Haltmaier and Steve Kamin (2002) - where the authors argued:

We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

As some economist or other I read is in the habit of saying "history has a nasty habit of repeating itself, the first time as tragedy and the second time as tragedy". Or put another way, here we go again. Hello, is there anyone out there?