RPT-Fitch: Eurozone deflation unlikely, but a risk to periphery

Fri Mar 14, 2014 5:46am EDT

March 14 (Reuters) - (The following statement was released by the rating agency)

The risk of deflation is most significant, albeit still low, for the eurozone among the world's major advanced economies (MAEs), Fitch Ratings says. Eurozone inflation is already the lowest among MAEs, and policy options to respond to potential deflationary shocks are more limited than elsewhere.

We think the eurozone's economic recovery will continue in 2014-2015 (we forecast 1.1% real GDP growth this year and 1.4% in 2015), as in other MAEs. This would make an increase in domestic disinflationary pressures unlikely, as we do not expect the negative output gap to widen further. But inflation was just 0.8% in February 2014, compared with the ECB's target of below but close to 2%. And while the probable policy response by central banks is one reason we think prolonged deflation is unlikely in any MAEs, the ECB is near the zero lower bound of nominal interest rates, and could face political and legal challenges if it tried to embark on quantitative easing.

In addition, regional inflation dispersion is limited. Inflation is below the eurozone-wide target in core as well as peripheral countries. The lower the average inflation, the longer and more costly will be the peripheral countries' recovery of lost competitiveness.

We estimated seasonally adjusted, quarter-on-quarter annualised core inflation for the eurozone, US, UK, and Japan as part of our quarterly "Global Economic Outlook". Shorter-term rather than year-on-year indicators give an underlying indicator of inflation rates if recent trends persisted for an extended period. This indicator is lowest for the eurozone, at 0.7%-0.8%, slightly below that for Japan.

Our underlying indicator is close to core year-on-year inflation, suggesting that if there are no shocks a further decline in the eurozone's core inflation is unlikely in the near term.

Nevertheless, the protracted adjustment in the periphery, combined with price and wage stickiness, would add to the costs of periphery rebalancing and increase the real value of the debt burden, and so could ultimately also add to deflation risks.

Overall, alongside likely central bank responses, we think a strengthening economic recovery and anchored inflation expectations make protracted, self-reinforcing deflation unlikely in the MAEs unless there are additional shocks.

Our full analysis is contained in our new "Global Economic Outlook", alongside our latest global growth forecasts. The report was published on Thursday and is available at www.fitchratings.com.