As Europe Recovers from Recession, Will Inflation Follow?

By Jason Van Steenwyk

It’s been a tough few years for eurobulls. The European Sovereign Debt Crisis of 2010 threatened to break apart the whole shebang, causing the death of a currency, with individual nations facing externally-imposed austerity measures rattling their sabres about walking out of the whole arrangement, dumping the euro, and going back to their own currencies. Because Italians are nostalgic for the days of ₤2,000 lira for a cup of coffee, or something.

Well, the adoption of the euro in 2002 solved the problem of unwieldy numbers of zeros involved simply in the act of ordering a a cappuccino – the smallest Italian bank note in circulation by the time the lira was replaced by the euro was ₤1,000 – but it didn’t solve the problem of Italy, or Greece, or Spain, or Portugal or Ireland, for that matter. And it certainly didn’t solve the problem of Cypress. The profligate deficits each country ran on its own resulted in debts so big that Cypress had to resort to outright confiscation of bank accounts.

Naturally, the temptation is strong for any nation struggling with debt problems is to let its currency collapse, and repay the debt with much cheaper units of currency.

But the culturally conservative Germans – with  savings rate 3-4 times that of the United States* – weren’t going to see their great stores of financial assets they had built up over the years go down without a fight. And so Angela Merkel led a massive bailout effort to try to save the euro through imposing austerity measures on the wayward net debtor nations as a condition for assistance.

The effort paid off. The worst fears of those predicting the total collapse of the euro as a uniform currency have thus far proved unfounded. The European central bank, emboldened with the news that a year-plus long recession in Europe seemed to be coming to an end, rallied the euro with public promises to protect the bond markets and keep the euro sound. And so the euro strengthened solidly in the last months of 2013, and ranked among the strongest currencies for the year.

The Eurozone is by no means out of the woods, yet. A nasty recession from 2011-2012 knocked Europe for a loop, and tied central planners’ hands. But modestly improving economic growth allows European central banks more leeway to restrain growth somewhat to prop up the currency. Nevertheless, several Eurozone countries still cannot function financially on their own without significant help from the International Monetary Fund and the European Union, including Cyprus, Ireland, Portugal and Greece.

As a result of the precarious unemployment situation in these countries, the European Central Bank (ECB) drove its primary refinance rate down to 25 basis points above nothing.

The official inflation rate, annualized, in the Eurozone, is 0.9 percent, as of November 2013. That’s up slightly from the 0.7 percent mark in November, but below the 2.2 percent rate it posted for the year-ago period.

Broken out by sector, we see some evidence of substantial moderation in the hottest sectors of 2011, as the graph below shows:


Inflation, euro, Eurozone

Euro Inflation by Sector, 2011

As you can see, Europe in 2011 was racked by substantial inflation in, well, almost anything European families couldn’t put off buying: Transportation, housing, water, fuel, food and the occasional pint or smoke – all were at 3 percent or more.

Currently, the sector posting the highest inflation rate in the Eurozone is food, alcohol and tobacco, with a current annualized rate of 1.9 percent as of November, 2013 – which puts it substantially off the 2011 pace.

Europe is in a peculiar position. Ordinary economic theory would predict a moderation in inflation or even a price decline as an economy tips into recession, and then a gradual heating up as we head out of recession. But in Europe, we see quite the opposite: Inflation was substantial in 2011 as the Eurozone entered its latest recessionary period, and then backed off again as the economy recovered in late 2013.


Inflation, Europe, Euro, Eurozone

Euro Area Inflation By Sector 2011-2013











How can this be?

Well, it makes a bit more sense if you take a broader view:


Euro Inflation 1996-present


Euro, Eurozone, Inflation

Euro Inflation 1996-present







Looking at inflation data for the Eurozone going back to 1996, we do indeed see a sudden heat-up in 2006-2007 as the economy over much of the world revved into a speculative fervor – and then a spectacular collapse, and even sinking briefly into deflationary territory in 2008 as asset prices collapsed around the world.

Then we see a recovery back in the normal inflation range of 2 to 3 percent, until 2011, when inflation began to fall again. This coincides with the secondary European recession of the last year.

So if you take the longer view, Europe is not exempt from the laws of economics: Inflation heats up in strong economies, and backs off in weak ones.

So are we going to see the cancer of inflation eating away at the euro anytime soon? Probably not. Increased budgetary austerity and a stubbornly high unemployment rate of 12.3 percent are combining to create a nasty headwind, holding back prospects of a new Eurozone boom.

Which means we’re not likely to see inflation zoom up beyond the normal range of 2 percent or so anytime soon.

*Don’t laugh. The French are even better savers than the Germans!



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