European Economic Forecast 2015: A Story of Inflation

European economic outlookOn May 5, 2015, the European Commission released its spring 2015 European Economic Forecast. According to the forecasts, growth prospects haven’t been better in years. Will cheap oil and a devalued Euro help Europe overcome its biggest obstacle?

Economic Outlook in Europe

The latest economic forecast for Europe states that the region is going through a “mild cyclical upswing” due to lower oil prices, a cheaper euro, “steady” global growth, and supportive economic policies (less austerity). (Source: European Commission, May 5, 2015.)

Economic forecasts for 2015 and beyond are generally positive. For example, gross domestic product (GDP) and value of output for the European Union are set to expand at 1.8% this year and another 2.1% in 2016. However, in 2015, none of the heavyweights are expected to grow significantly, with only Ireland, Luxembourg, Malta, Slovakia, and Poland expecting growth above three percent. (Source: European Commission, May 5, 2015.)

Unemployment continues to decline since its peak in 2009. Investment in real assets is forecast to grow at 4.2 %—the fastest rate in over a decade. Overall, Europe’s labor market is improving and businesses are expected to spend more.

At the national level, current account balances and exports less imports are improving for many of the previously troubled European periphery nations, like Portugal and Italy. Great. But almost all European governments, except Germany and Luxembourg, are predicted to run budget deficits by 2016 year-end. European politicians across the continent continue to spend in excess of tax revenues. Growth is only slightly inching forward and inflation remains subdued.

Inflation and Structural Reforms

The latest reading of inflation in Europe, as of March 2015, stands at -0.1%. That is to say, prices are falling. However, economists remain positive. (Source: ECB, last accessed May 5, 2015.)

The European Commission expects the effects of lower commodity prices to fade, and a lower euro to result in higher import prices. This will therefore push consumer prices, a measure of inflation, from 0.1% year-over-year growth in 2015 to a 1.5% increase by 2016 year-end.

I believe this may be a likely scenario, as food costs, energy needs, and transportation prices make up roughly 50% of the consumer prices index. As commodity prices regain strength, consumer prices should follow. After all, inflation in the euro area was running at three percent as recently as November 2011.

It won’t be easy to spur inflation. Even with Europe’s measure of last resort, the $1.0-trillion quantitative easing (QE) program is in place until September 2016.

The problem is that oil prices remained strong. From 2011 until the summer of 2014, interest rates were falling and the euro was in a consistent decline—all while inflation continued to decline. In reality, the European economy stagnated because of an absence of structural reforms.

When speaking of structural reforms, European economists and policymakers are primarily referring to reforms needed in Europe’s labor market. Elevated wages on the European periphery, along with low productivity, caused large imbalances. Notably, EU members like Portugal, Italy, Ireland, Greece, and Spain lost their competitive advantage and began accumulating current account deficits—importing goods they could not competitively export.

A lack of competitiveness led to slowing economies and growing debt balances. Government gross debt, as a percentage of GDP, peaked in 2014; hitting 177% in Greece, 98% in Spain, and 132% in Italy. That’s way up from Spain’s average of 62% between 1996 and 2000, or Portugal’s average of 53% during the same period.

Real Risks to the Outlook

The issue of elevated wages and staggering debt levels closely connects back to inflation.

Higher inflation would allow countries that are unable or unwilling to make structural reforms to reduce their wages and debt balances—making their economies competitive. For example, keeping wages constant and having price levels increase reduces the real wage paid, thus reducing worker costs without politically unpopular reforms. (Source: The Economist, September 8, 2014.)

But, with Europe’s QE program aimed at improving credit conditions and lowering interest rates already in gear, not much more can be done to increase growth or inflation.

When interest rates are already near zero to negative inflation, falling prices make real interest rates rise. This is the opposite of what Europe’s Central Bank hopes to achieve. Higher interest rates make it harder for European states with large debt balances and slow growth to reverse course. In fact, low inflation and high debt balances are the primary culprits in Europe’s continued economic despair.

For example, Europe’s equivalent of the federal funds rate, the interest rate large banking institutions charge one another for overnight lending, stands at 0.05%. That’s essentially zero. (Source: ECB, last accessed May 5, 2015.)

With lower rates nearly impossible, I believe that the possibility of low inflation or even deflation remains the biggest risk to Europe’s economic outlook for 2015 and beyond.