Eurozone deflation could derail UK recovery: Results of the second Centre for Macroeconomics survey

Angus Armstrong, Francesco Caselli, Jagjit Chadha, Wouter den Haan 13 May 2014



The Centre for Macroeconomics (CFM) – a partnership between the University of Cambridge, the London School of Economics (LSE), University College London (UCL), the Bank of England and the National Institute of Economic and Social Research (NIESR) – is today publishing the results of its second monthly survey to inform the public about the views held by leading UK-based macroeconomists on important questions about macroeconomics and public policy.1 The survey aims to shed light on the extent to which there is agreement or disagreement on these questions among our panel of experts.

This month’s first question concerned the severity of the deflation risk facing the Eurozone. Although many economists felt that the deflation threat was tangible, the balance of probabilities was that European Central Bank (ECB) policy would be loosened sufficiently to prevent a deflation and this was probably reflected in measured inflation expectations, which remain close to the ECB’s target.

This month’s second question concerned the likely impact of any Eurozone deflation on the UK’s economic recovery. To the extent that a sustained Eurozone deflation might occur, economists identified several possible avenues that threatened the UK recovery, ranging from net exports, economic and political uncertainty, through to the impact on the balance sheets of financial institutions. But note that a significant minority did feel that the UK recovery was strong enough to withstand a further contractionary impulse from the Eurozone.

Deflation risks facing the Eurozone

The first question centred on the immediate risk of a Eurozone deflation. The annual rate of change in the Eurozone HICP (Harmonised Index of Consumer Prices)2 was estimated at 0.5% in March 2014 and has been below 1% since October 2013. Despite this dip in measured inflation, inflation expectations do not suggest any widespread concern about deflation. For example, the mean of longer-run inflation expectations from the ECB’s survey of professional forecasters is 1.9%; the mean of short-term inflation expectations is also above 1%; and long term forecast measures obtained from financial prices also remain above 2%.3

But it has been argued by some commentators that sluggish growth rates in many Eurozone countries will have the scope to trigger a surprise deflation, perhaps similar to what has happened in the past in Japan.

For the question, we suggested to respondents that they define the risk of an event as “significant” if their subjective probability of the event exceeds 25% and “sustained” as corresponding to a duration of at least two quarters (and probably more) in succession of negative annual CPI (consumer price index) inflation across the Eurozone. And we suggested that they might wish to employ their own numerical definitions, and explain any such definition in their commentary.

Q1: Do you agree that there is a significant risk of a sustained deflation across the Eurozone in the coming two years?

Survey results on Eurozone deflation

The survey produced finely balanced results but with a small majority inclined to think that the risk of a deflation was not significant. While 54% of respondents disagreed (43%) or strongly disagreed (11%) that there was a significant risk of a sustained Eurozone deflation over the next two years, if we weigh the responses by the degree of certainty, the overall majority disappears.

The NIESR’s latest forecast, summarised by Angus Armstrong, does project a significant risk of deflation as it “ha(s) Eurozone inflation of 0.1% to 0.2% in the third and fourth quarters of this year as a central case, (meaning that) (d)eflation, as defined, would certainly fall within a 25% probability around this central case. The critical question would then become what happens to expectations, which in some part depends on the ECB.”

Chris Pissarides (LSE) captured the mood of many respondents by arguing that, “(i)f the ECB continues with its current policies there will be a significant risk of sustained deflation. But recent talk from the ECB indicates that they are aware of the risks. A change of ECB policy can surely avert deflation so my expectation is that when we reach the precipice under present policies there will be a change of policy (e.g., further fall in interest rates or QE) to avert it.” Wendy Carlin (UCL) pointed to “anchored inflation expectations” and Patrick Minford (Cardiff University) highlighted the role of “inflation targets… hav(ing) enormous credibility and lead(ing) to a considerable stabilis(ation) of actual inflation around… targets.”

Potential spillovers to the UK recovery

Deflation is generally thought to be pernicious because it raises real debt burdens and makes it more difficult for policy-makers to achieve a level of real interest rates low enough to stabilise the economy. This may lead to self-fulfilling negative inflation and output dynamics. Deflation in the Eurozone, which as a region constitutes the UK’s major trading partner, is likely to transmit a contractionary impulse to the UK economy through its impact on confidence, net exports and the vulnerable financial sector. This impact may be great enough to halt the recovery, which has seen output nearly return to its level at the previous cyclical peak in 2008 Q1.4

Q2: Do you agree that a deflation in the Eurozone (as defined in Question 1) would pose a considerable risk to the UK recovery?

Survey results on the impact on the UK’s economic recovery

The survey produced a clearer consensus that should a Eurozone deflation occur, it would pose a considerable risk to the UK economy: 64% of respondents in both the simple and weighted version of the survey agreed with the question and not one respondent strongly disagreed.
The risk to the recovery depends first on how strong it actually is. There was some disagreement here with Wouter Den Haan (LSE) suggesting that “the UK recovery is still fragile”, whereas Nick Oulton (LSE) felt that “indications for the UK are currently so strong that I would not expect low inflation in the Eurozone to derail the UK recovery” and Simon Wren-Lewis (University of Oxford) “doubt(ing) that weak Eurozone growth would be enough on its own to halt the UK recovery.”

The possible responses to a Eurozone deflation by the ECB may not be sufficient to pose a risk to the recovery. David Smith (Sunday Times) felt that although a Eurozone deflation “could boost sterling against the euro. Given that sterling is undervalued against the euro, I do not think this would pose a huge risk for the UK recovery. The bigger risk would be if deflation triggered more general eurozone uncertainties.”

In a similar vein, Martin Ellison (University of Oxford) felt that “the flexibility of an independent exchange rate for the GBP may give some hope that policy options could mitigate the effects of disinflation in the Eurozone, but possible balance sheet effects of non-GBP denominated debts would be worrisome.”

A number of respondents stressed the vulnerabilities of financial balance sheets. Tony Yates (University of Bristol) argued that a “it may also mean a period of renewed heightened uncertainty about the ability of the ECB to hold the EZ together, and about the health of the EZ sovereigns and banking system. The latter could easily spark a renewed rise in spreads in UK risky assets.” Chris Martin (University of Bath) felt that a there was risk of a “falling asset values and rising levels of real debt that will hit the balance sheets of financial institutions. This may well spill over into increasing risk premia and a more general reluctance to lend in the UK.”

1 Results are available at
3 Specifically, the five-year forward break-even inflation rate five years ahead and the five-year forward inflation-linked swap rate five years ahead, see Chart 14 on page 33 of the ECB’s April 2014 Monthly Bulletin (
4 On 29 April, the ONS estimated that in 2014 Q1 the UK economy was only some 0.6% below the previous peak in 2008 Q1.



Topics:  Macroeconomic policy

Tags:  Eurozone deflation

Director of Macroeconomic Research, National Institute for Economic and Social Research

Professor of Economics at the London School of Economics

Director, National Institute of Economic and Social Research

Professor of Economics, London School of Economics and CEPR Research Fellow


CEPR Policy Research