UPDATE 1-ECB's Noyer - Falling inflation increases deflation risk in Europe

Mon Jun 9, 2014 11:04am EDT

(Adds remarks on threat to recovery, paragraphs 1, 4-8)

By Alastair Sharp

MONTREAL, June 9 (Reuters) - European Central Bank policymaker Christian Noyer highlighted low and falling inflation on Monday as Europe's main short-term problem, saying it heightened the risk of actual deflation and could threaten economic recovery.

"The main challenge, of course, is low and declining inflation, with inflation expectations in the euro area drifting downward at short to medium-term horizons," Noyer, the French central bank chief and member of the ECB board, told the economic Conference de Montreal.

"This prevents adjustments in relative prices, an important mechanism to eliminate gaps in competitiveness, and it increases the risk of outright deflation, should a negative shock occur in the future."

It is puzzling that in the euro area inflation and growth are moving in opposite directions, he said: "As growth accelerates, inflation keeps going down."

To try to understand why, he looked at strong capital inflows into euro area economies in recent months, which had two opposite effects on financial conditions - lower long-term interest rates but an appreciation of the euro exchange rate.

"It's not clear whether the overall effect is positive. While nominal conditions are more accommodating in (the) euro area than in the U.S., real indicators point to a more restrictive stance," he said.

"We may see a perverse feedback loop develop, with low inflation, increasing real rates, capital inflows and exchange rate appreciation mutually fueling each other. The financial economy may be heading towards a bad equilibrium that would threaten the real economic recovery."

He said such a situation called for a real policy response, which is why the ECB brought in a series of strong measures last Thursday, including imposing negative interest rates on deposits. (Writing by Randall Palmer in Ottawa; Editing by Chizu Nomiyama and Tom Brown)

A couple walks along the rough surf during sunset at Oahu's North Shore, December 26, 2013. REUTERS/Kevin Lamarque

Find your dream retirement town

Florida? Hawaii? Reuters has teamed up with Zillow to give you the power to customize a list of your best places to retire.  Video | Full Article