Japan-style deflation risk in Europe getting harder to ignore

LONDON Thu Feb 13, 2014 11:07am EST

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LONDON Feb 13 (Reuters) - The risk of the euro zone sliding into an economically and financially damaging spiral of deflation similar to Japan's 20-year experience from the mid-1990s is rising, according to a growing number of leading economists.

This counters the prevailing consensus among policymakers, who insist there is no threat of deflation, and financial markets, which are not pricing in or positioning for such an eventuality.

In its widely read annual "Equity Gilt Study", Barclays drew parallels between Japan and the euro zone, concluding that the risks of a prolonged period of falling prices in the 18-nation bloc was "significant".

Economists at JP Morgan are more sanguine, but they wrote in a research note on Thursday that given Japan's experience, "no one should be surprised if it happens".

Inflation across the euro zone is falling fast, and was last measured at an annual rate of just 0.7 percent, well below the European Central Bank's target of "below, but close to" 2 percent, the lowest in the developed world, and down from 3 percent barely two years ago.

Deflation tempts consumers to postpone spending and businesses to delay investment because they expect prices to be lower in the future. This slows growth and puts upward pressure on unemployment. It also increases the real debt burden of debtors, from consumers to companies to governments.

European leaders insist the threat is low. ECB president Mario Draghi said last week: "We have to dispense once more with the question: Is there deflation? and the answer is 'No'."

And German fiance minister Wolfgang Schaeuble told Reuters this week: "There is no deflation danger in Europe."

But there are parallels between Japan and the euro zone including asset price deflation, falling house and land prices, a strong exchange rate acting as a drag on prices, tight fiscal policy and a collapse in bank lending.

Deflation was likely to strengthen the euro, harm stocks and be "very unwelcome" for peripheral euro zone countries' debt sustainability, Barclays said.

The euro zone is at the very early stages of its fight to ward off deflation, while Japan took 20 years to defeat it. Consumer prices in Japan are now rising twice as fast as those in the euro zone.

"The early-stage drivers of Japan's deflationary shock are nearly all present in the euro zone today," Barclays said.

"The risks of a region-wide deflationary period are significant, and certainly bigger than what is currently priced into financial markets or being publicly acknowledged by euro zone policymakers," it added.

Their counterparts at JP Morgan note that the economic environment in the euro zone in 2014 is very different to that in Japan two decades ago.

But there are lessons to be drawn: an economy can slide into deflation without policymakers and the private sector realising it is about to happen; well-anchored inflation expectations or moderate growth do not necessarily prevent deflation; the central bank should err on the side of caution and pursue looser policies than might seem appropriate.

"We are especially concerned about the reluctance of the ECB to set the policy stance consistent with the prevailing macro landscape, let alone one that leans against downside risks," they said in a note on Thursday.

The ECB last week kept interest rates on hold at a record low 0.25 percent and refrained from introducing any other policy measure such as more cheap lending to banks. (Reporting by Jamie McGeever; Editing by Louise Ireland)

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