Bond market prices imply German deflation

posted in: Economics | 2

As the Financial Times shows today, German bund (government bond) yields are now higher than British gilts. This is not something that the UK should feel great about as it reflects a general pessimism about the Eurozone prospects and a likely expectation of very low inflation in the UK, arising from low economic growth.

German 5 year breakeven inflation (the implied expectation of future inflation derived from subtracting the inflation-linked real yield from the nominal bund yield) shows a steady fall recently and is now below 1% (see chart below). As Paul Krugman says, this implies deflation in future, as you would expect in a combination of Euro break up, banking collapse and generalised recession.

Source: Bloomberg

Happy thanksgiving.

2 Responses

  1. Vuyo Gugushe

    If this deflation scenario does play out, what do you think will be the impact on the ECB’s policy of sterilized bond purchases – surely they will have to begin implementing UK and US style quantitative easing? This is even more so given that the general theme in the region is fiscal austerity – “abnormal” monetary policy will have to come in to save the day?

    • Simon Taylor

      If deflation becomes a clear prospect, the ECB’s duty is to take steps to reverse it. Their mandate requires them to achieve low inflation, not deflation. They would probably be as pragmatic as the Fed and Bank of England at that point, but neither of those banks has achieved much with their non-standard policies. The BoE’s own analysis shows very little impact of buying gilts on the interest rates faced by corporates. The ECB could justify buying a lot more sovereign debt now if it was to prevent future deflation, rather than justify it as helping out distressed countries. But they are naturally reluctant to take steps that are associated with “printing money” (ie funding government deficits by creating money) if it seems they’re doing so only to help bail out the Euro. And yet a collapse of the Euro would likely be a very deflationary event indeed so it could still be justified by their normal inflation mandate. There is a sense among many economists that the ECB is deliberately putting pressure on Italy to deliver some substantial and credible fiscal cuts. Only then will the ECB come in with larger bond purchases, possibly unsterilised. Trouble is, by that time it may be too late and investors have dumped all Euro sovereign bonds, which now appears to be happening.

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