UPDATE 1-Surprise drop in euro zone inflation shows deflation risk

Tue Jan 7, 2014 6:07am EST

* December inflation surprises with drop to 0.8 pct y/y
    * Concerns that euro zone faces deflationary risks
    * Euro rises versus dollar after Dec CPI
    * Producer prices fall in November but ease decline


    By Martin Santa
    BRUSSELS, Jan 7 (Reuters) - Euro zone inflation fell in
December after a small increase the previous month, increasing
the European Central Bank's challenge of avoiding deflation as
well as supporting the bloc's recovery.
    Consumer price inflation in the 17 countries then sharing
the euro stood at 0.8 percent year-on-year in the last month of
2013, compared with 0.9 percent in November, data from the EU's
statistics office Eurostat showed on Tuesday. 
    December's reading takes inflation back to near a
four-year-low of 0.7 percent in October. 
    "Today's figures show that it's too early for the ECB to
become complacent about deflation risks, especially in
peripheral countries," said Peter Vanden Houte, ING's chief euro
zone economist, referring to the bloc's weaker members.
    An inflation rate that is well below the ECB's target of
close-to-but-below 2 percent carries risks in the longer term
because it can deflate wages and demand, depressing the economy.
    Reacting to the data, the euro rose to $1.3646 from $1.3618
on speculation the ECB could consider more steps to support the
economy. 
    The October drop in inflation was the first fall below 1
percent since February 2010 and prompted the European Central
Bank to cut its key interest rate to a new record low of 0.25
percent in November.
    Still, the euro zone is far from the deflation that Japan
suffered from the early 1990s.
    ECB President Mario Draghi said last week there were no
signs of deflation or an urgent need for another rate cut, but
added that it was vital to avoid a scenario where inflation gets
stuck permanently below one percent and slips into a danger zone
for the economy.
    "While we believe that for the time being the ECB will keep
its monetary policy unchanged, not much is needed to push the
central bank into action," said Vanden Houte.
    Analysts see the ECB staying on hold at its rate-setting
meeting on Thursday, while watching out for any action the bank
may take in reaction to current low inflation environment.
    "We believe the ECB will most likely enact its Long-Term
Refinancing Operation (LTRO) in the next few months, which may
very well be tailored specifically towards bank lending," said
IHS chief European economist Howard Archer.
     ECB Governing Council members have signalled the bank will
provide more money to banks by the time the cheap long-term
loans it has already made expire. The ECB injected more than 1
trillion euros into the banking system via three-year loans in
December 2011 and February 2012, which means the first tranche
of repayments is due in late 2014.
    Eurostat's separate data release showed euro zone industrial
producer prices eased their decline in November to fall by 0.1
percent on the month after a 0.5 percent drop in October,
putting the annual rate at -1.2 percent, compared with a nearly
four-year low of -1.3 percent seen in October.
    The monthly drop was led by a 0.2 percent fall in costs of
intermediate goods while prices of capital, durable, non-durable
goods and energy prices were flat compared with October.
    Changes in producer prices, unless absorbed by retailers,
eventually translate into changes in the consumer price index.
    Eurostat's detailed inflation data breakdown for December,
country by country, will be published on Jan. 16.
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