The International Monetary Fund says the probability of the world economy falling into a deflation trap may now be as high as 20%.
It is remarkable that the G2 monetary superpowers – the U.S. and China – should both be tightening into this risk, though perhaps they are already damned either way given the level of asset speculation.
“We need to be extremely vigilant,” said the IMF’s Christine Lagarde in Davos. “The deflation risk is what would occur if there was a shock to those economies now at inflation rates below target. I don’t think anyone can dispute that eurozone inflation is way below target.”
The shock is already before our eyes as Turkey, India, and South Africa hit the brakes, forced to defend their currencies as global liquidity drains away.
The World Bank warns that withdrawal of stimulus by the U.S. Federal Reserve could throw a “curved ball” at the international system. “If market reactions to tapering are precipitous, developing countries could see flows decline by as much as 80% for several months,” it said. They may need capital control.
Roughly US$4-trillion (pounds 2.4-trillion) of foreign funds swept into emerging markets after the Lehman crisis, mostly by then “momentum money” late to the party.
The IMF says US$470-billion is directly linked to money printing by the Fed. “We don’t know how much of this is going to come out again, or how quickly,” said an IMF official.
Europe has let its defences collapse behind a Maginot Line of contractionary policies. Eurostat data show that Italy, Spain, Holland, Portugal, Greece, Estonia, Slovenia, Slovakia, Latvia, as well as euro-pegged Denmark, Hungary, and Bulgaria have all been in outright deflation since May once taxes are stripped out. Prices have been dropping in France since August.
Eurozone M3 money growth has been negative for eight months. Bank credit to the private sector has fallen by euros 155-billion (pounds 127-billion) in three months, according to the European Central Bank.
The U.S. has a slightly bigger buffer, but not much. Growth of M2 money has been slowing even faster than it did in the six months before the Lehman crash, but then the Fed no longer pays any attention to such data so it may well repeat the mistake. The Fed is surely courting fate by cutting off US$10-billion of stimulus each meeting in the face of incipient deflation.