Europe: Deflation Still Remains The Issue And The Euro Continues To Rise

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Includes: DIA, FXE, IWM, QQQ, SPY
by: John M. Mason

Summary

Inflation in eurozone lowest since November 2009.

This implies that the value of the euro against the dollar will continue to rise as US inflation is greater.

Since much of the economic adjustment taking place may be structural, the return to "normal" may take a long time.

The headlines state the issue, "Fresh Data Add to Eurozone Deflation Fears," an article by Claire Jones.

The story begins, "Inflation in the eurozone hit its lowest level in more than four years in March, stocking fears that the currency bloc is drifting towards a damaging period of falling prices."

How real is this fear?

Real enough so that the value of the euro keeps going up relative to the dollar. The value of the euro, relative to the dollar, closed at 1.2126 on July 23, 2012 and has risen, almost steadily, since that date.

On March 31, 2014, the euro closed at 1.3775, which is down slightly from a recent peak of almost 1.40 during the week of March 10.

This is an increase of more than 15 percent in just about 20 months.

And, investors seem to expect that this increase will continue into the foreseeable future.

Jones writes that "the European Central Bank expects inflation to remain below its target at least until the end of 2016, when it have forecast a reading of 1.7 percent."

The most recent rate of inflation in Europe was reported to be 0.5 percent.

As for the United States, the year-over-year rate of increase in the consumer price deflator has averaged around 1.0 percent over the last six months. And, most economists expect the rate of inflation to increase from here.

This is a recipe for the value of the euro to continue to climb against the dollar.

The ECB, as well as the Federal Reserve System in the United States continues to follow a monetary policy of relative ease, now and into the near future. The quandry pursing the ECB is whether or not it should try to "loosen" even further, whatever that means.

The concern in Europe is that it is entering into a period of "Japanese-style deflation." Christine Lagarde, the managing director of the IMF has expressed her concern about the European situation and has dubbed deflation as "the ogre that must be fought decisively."

So, Mario Draghi, the president of the ECB, continues to speak out about the need to make sure that Europe does not slide into a period of deflation. However, there is just so much that monetary policy can do.

Janet Yellen, the chairwoman of the Board of Governors of the Federal Reserve System, is also facing a task that is not unsimilar. And, yesterday she attempted to address the issue in her first speech as the Fed's Chairwoman.

The headlines coming from this speech, however, is that the "Fed is Determined to Improve the Labor Market." Having visited work sites over the past week or so, Ms. Yellen laced her remarks with live examples of people that exist within today's labor market. The promise she delivered in the speech was that the Fed cannot let go of its responsibilities to see a more vibrant labor market.

Funny, when I was learning my economics it was generally assumed that monetary policy could do very little to affect "real" markets ... like labor markets. Obviously, the times, they have changed!

My deepest concerns for Europe as well as the United States is that the there are very severe structural problems in these economies, that must be overcome before we can return to a more "normal" environment. Europe and the United States face some major restructuring issues ... issues that only come about once in a century or so. And, some say, this is a problem that Japan fell into during its recent bout with deflation.

The Financial Times article alludes to this structural problem. Ms. Jones writes "The ECB has claimed that some of the disinflation is good news, coming on the back of a drop in relative labor costs in peripheral economies that has made weaker member states more competitive."

And, if there are major structural issues that must be dealt with before a full economic recovery can take place, monetary policy can do very little to help achieve this re-structuring. The adjustments must take place, and if the only things that can speed on this recovery is improving the re-training and educational systems of these areas, then the return to "normality" is going to take a substantial period of time.

In this respect, Europe, I believe, has a further way to go than the United States. That is, as the ECB expects, disinflation, or, possibly even deflation will be stronger in the eurozone than it will be in the United States. And, as I mentioned above, this is a recipe for the euro to continue to appreciate in value with respect to the dollar.

And, this will continue until the time arrives when the restructuring in Europe and in the United States comes to an end. We all want "normality" to return, but unfortunately, I don't believe that this is going to happen for quite some time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.