The eurozone is beginning to resemble Japan with its low-growth and low-inflation environment, coupled with still very loose monetary policy, according to economists at ING.
This raises questions about the European Central Bank's tool kit and firing power.
Interest rates haven’t gone up in either the eurozone or Japan since the aftermath of the global financial crisis. Conversely, the Federal Reserve has raised rates nine times since the crisis years, presumably giving it room to cut them again should the economy need a boost.
The Bank of Japan is considered the most hesitant of its peers to normalize monetary policy. And already since the mid-1990s, Japan has been struggling with a high public debt ratio and stubbornly low inflation and growth rates. None of that bodes well for a hawkish central bank approach.
The eurozone looks like it entered a similar trend of late, said ING economists Carsten Brzeski and Inga Fechner, one day ahead of the European Central Bank’s next policy update.
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“An end to current unconventional monetary policy, i.e. the negative deposit rate and ample liquidity, is not insight and the ECB is expected to do everything it can to avoid an unwarranted tightening of its monetary stance.”
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“Last year, Japan’s debt-to-GDP ratio stood at 238%, and since 1994, headline inflation has been negative for almost half of the time. This trend has also emerging in the eurozone in recent years,” said Brzeski and Fechner, pointing at Greece, as well as Spain and Italy, in the aftermath of the European sovereign debt crisis. Though deflationary risks have disappeared in the eurozone, consumer prices haven’t exactly been soaring.
According to the ING economists’ model — taking into account economic growth, inflation, short-term interest rates and demographic change — the eurozone has started to look more like Japan since 2013. The below chart shows their findings.
“Over the last couple of years, the eurozone economy has left its ‘normal’ growth path following the global financial crisis and has dipped into ‘Japanification-territory,’ which Japan has not left for a quarter century,” they wrote.
Demographics are another example of apparent conversion.
“While Japan has the world’s oldest population, the working age population in the eurozone started to shrink in 2009 and these estimates already take into account some continuing immigration over the next few decades,” said Brzeski and Fechner.
The theory says that wage growth should be muted in an ageing economy, due to rising retirement levels. And Japan is just the example the professor ordered, with subdued wage growth, low unemployment and a declining workforce.
But what if this is just a blip?
Japan hasn’t reached the BOJ’s inflation target rate since 1993, apart from a sales tax hike in 2014 that pushed it higher. Meanwhile, eurozone inflation is much closer to the 2% area the ECB is hoping for. The currency bloc’s debt burden is also still lower and it has avoided slipping into deflation territory in the aftermath of the financial crisis.
And “when it comes to fighting the symptoms at least, eurozone authorities have been much faster than their Japanese counterparts.”
Still, the similarities remain striking, and worrying.
“The current situation and the prospects of some kind of Japanifaction support our view that interest rates [in Europe] will remain lower for much longer.”
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