Pedro Relloso does not know what the term deflation means, but he certainly knows what it looks like.
For more than 40 years, he has been manning the till of a corner shop owned by his brother in the centre of Madrid, surrounded by boxes of fruit and vegetables, cans, biscuit packages and bottles of Spanish wine stacked neatly on shelves that reach all the way to the ceiling.
Mr Relloso points to a rack of sweets right by the entrance door. “These chewing gums there, we used to sell them for €1 for a package. Now we sell two for €1.50.” The fall in prices has also reached the brightly lit fridge where he stocks milk, butter and cheese. Yoghurts, says Mr Relloso, are now 10-15 per cent cheaper than they used to be. “Over the last year, the price of many goods has fallen quite a lot. Competition is very hard, people have less money and if you don’t adapt you die,” he says with a shrug.
From the shop of the Relloso brothers in Madrid to the European Central Bank in Frankfurt and investors in London, everyone seems to be worried about falling prices these days. When the ECB revealed an unexpected cut in interest rates last week, the move was widely interpreted as a direct response to the sharp fall in inflation rates in the single currency zone. Across the 17-nation eurozone, inflation stood at only 0.7 per cent in October, well below the bank’s target of just below 2 per cent.
Spain, which just emerged from more than two years of painful recession, experienced a particularly sharp fall. In October, the country’s measure of monthly inflation turned negative for the first time in four years, dropping to -0.1 per cent compared with 3.5 per cent in the same month one year ago.
“We are playing with fire here,” says Federico Steinberg, senior economist at the Real Instituto Elcano, a Spanish think-tank. “If we assume that economic growth will be low in the foreseeable future and that monetary policy will not be very expansionary, then I see a real risk that Spain falls into deflation.”
Economists point out that deflation, if and when it takes hold, is particularly menacing for countries trying to recover from a borrowing binge. That is clearly the case in Spain, where private sector debt stands at about 200 per cent of gross domestic product.
When prices fall, the real value of debt rises, which in turn makes it harder for already struggling families and businesses to service their loans. “Deflation is a really big problem for debt dynamics,” says Edward Hugh, a Barcelona-based economic commentator. “This is about a slow, corrosive process that eats away at your vitals.”
Another concern relates to consumption: “With deflation, people start assuming that whatever they want to buy will be cheaper next month or next year. That reduces consumption and prolongs the slump,” says Mr Steinberg.
Spain is, by all accounts, still some way from experiencing the kind of protracted fall in prices across the board that is commonly associated with deflation. The country has so far only had one month of negative inflation, and most forecasters expect a return to low but positive inflation rates over the coming months. That, say many economists, is exactly what Spain needs.
Jordi Gual, the chief economist at Caixabank, argues that low inflation is above all the consequence of Spain’s effort to become more competitive by holding down wages and other costs. “We need several years during which inflation in Spain is lower than the eurozone average,” says Mr Gual.
The problem, he adds, is that eurozone inflation is so low at the moment that prices in Spain have to fall even further to reflect that catching-up process. “What worries me is inflation at the eurozone level. If average inflation is way below the ECB’s target, then the risk is always that inflation in a country like Spain is too low.”
Economists agree that the biggest danger for Spain, and other low inflation countries in the eurozone, is that consumers and businesses start to expect price falls in the months and years ahead, making deflation a self-fulfilling prophecy. That is not the case yet, and many believe it is unlikely in the future. But, as Mr Hugh points out, one does not have to dig too far to find a cautionary tale for policy makers in Madrid and Frankfurt: “Just look at what happened to house prices in Spain. Not so long ago, people really did believe that house prices would go on rising forever.”
Back at Mr Relloso’s corner shop, some of that same dynamic is now on display. The brothers used to push through small price increases every so often to keep their margins stable. That, says Mr Relloso, is no longer an option. “People buy less and we earn very little.”
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