Deflation looms as next challenge on horizon

By Krista Hughes and Mark Felsenthal - Analysis

FRANKFURT/WASHINGTON (Reuters) - With recession now a reality in major economies from Japan to Germany, policymakers are starting to fret about the chance of a phenomenon many see as even more deadly: deflation.

Japan's decade-long battle with steadily falling prices and economic stagnation looms large in officials' memories and central banks and governments are determined to avoid past mistakes.

"Deflation is probably the worst case for the financial sector because it is very difficult to overcome. Therefore all central banks are going to do everything to avoid it," European Central Bank policymaker Ewald Nowotny said on November 10. The prospect of constantly falling prices is particularly unwelcome at present given the blow it deals to efforts by banks, firms and households to cut debt and help weather the economic storm now following the financial market crisis.

Central banks, faced with a sudden collapse in growth as well as inflation, have already slashed interest rates and are expected to keep doing so, although economists warn they may run out of rope before prices hit rock-bottom.

"Monetary policy is less powerful on the way down than on the way up," said Stefan Gerlach, professor at the Goethe University of Frankfurt's House of Finance.

"When inflation is rising central banks can raise rates as high as they like, but in the other direction, there's a bound of zero."

The U.S. Federal Reserve has already cut rates to 1 percent, while the Bank of Japan's key overnight rate stands at just 0.3 percent. The ECB, with official rates at 3.25 percent, and the Bank of England at 3 percent have somewhat more room to move.

After hitting historic highs just a few months ago, inflation is falling in all industrialized economies on the back of faltering growth and a sharp drop in energy and food prices. Oil has lost about two-thirds of its value since a peak above $147 in July, to trade around $53 per barrel.

U.S. consumer prices plummeted at their sharpest rate on record in October, fanning fears of a deflationary spiral of falling prices, spending and wages if demand does not pick up.

Fed policymakers have played down the risk of deflation -- which goes beyond a temporary period of negative inflation -- as have their colleagues at the ECB, although BoE Governor Mervyn King has said he cannot rule out deflation in the UK.

"HOLE IN THE HEAD"

Another effect of falling prices is to increase the burden of any given amount of debt, even as banks and households are sharply paring debt, or deleveraging, in reaction to financial turmoil and a wave of bad economic news.

"The problem with negative inflation is that the real value of your debts is increasing," Societe Generale economist James Nixon said.

"In a deleveraging cycle you need negative inflation like you need a hole in the head."

In the United States, the credit crisis and the abrupt deceleration of the economy since mid-September are a one-two punch that make it harder for authorities to shield the economy from deep recession and heal credit markets.