The UK's NIESR has been running some numbers, and a further appreciation of the euro/dollar by 20% would push the entire eurozone average inflation below zero. Back to Gerard Baker, if this is a market valuation, there is nothing we can do, right. Wrong. And the sooner the finance ministers pack their bags and get bag to Deauville, and some hard thinking, the better. Or is it, after the pain will come the pleasure?
The eurozone's economy is likely to fall into deflation if the euro returns to its equivalent peak levels of the mid-1990s, according to one of Britain's most respected economic forecasters.Simulations by the National Institute of Economic and Social Research, prepared for European central banks and finance ministries that use them for comparison with their own models, suggest that if the euro rises by about another 20 per cent, there is a roughly two in three chance that it will push average inflation for the eurozone below zero.Such a move would not be unprecedented: the dollar has fallen 29 per cent against the euro since its peak in 2000. In 1985-87, it fell by 54 per cent against the D-Mark.The fall of the dollar has been gathering momentum, and international investors seem increasingly concerned by the US combination of a vast current account deficit and low interest rates. A rise from the euro's current level of about $1.17 back to 1995 levels, equivalent to about $1.40, seems far from impossible.
Ray Barrell of the NIESR said: "At the moment, the chances of inflation falling below zero in the eurozone as a whole are quite low: perhaps 5 per cent. But if the euro were to rise to those 1995 peaks, then the chance of deflation in the eurozone is better than even." It would also take up to 1.8 per cent off the eurozone's gross domestic product, he said, threatening to push it into recession, or at least a further period of slow growth. A rise in the euro against the dollar is also likely to be bad for global growth as a whole, because it hurts the eurozone more than it benefits the US. "Because the eurozone economy is nowhere near as flexible as the US, eurozone output will fall more than US output rises," Mr Barrell said. The impact would depend on how the euro moved against other currencies apart from the dollar: if other currencies are also rising, the effect would be less. Most economists do not currently see deflation as an imminent threat to the eurozone. "I don't think it is just around the corner, except in Germany," said Robert Barrie of Credit Suisse First Boston. "But there are problems there, and policy isn't doing much about them. You can bet that interest rates are not as low as they would be if they were being set for Germany alone."
On Monday Gerhard Schröder, Germany's chancellor, said he did not see "any danger of deflation in Germany", rejecting the warning from the International Monetary Fund that "mild deflation is fairly likely to take hold even though the risks of pernicious deflation are low". But the rise in the euro threatens to kick away the support from a relatively strong trade position that has supported the German economy in the last few years. Reinhard Kudiss, economist at the BDI industry federation, said German companies were less well-placed to withstand a strong exchange rate than in the mid-1990s. "Many companies are very worried," he said. "For many, the domestic German market has been a challenge for some time. If, in such an environment, the export side also comes under pressure, the situation becomes even more difficult." With German inflation typically running at about 1 percentage point below the eurozone average, even a move towards zero inflation in the eurozone would be likely to mean deflation for Germany.
Source: Financial Times