* Draghi sees euro zone deflation risks as "quite limited"
* Japan experience shows how deflation can gradually take
* ECB policy options limited by high barriers to all-in QE
* Deflation risk "linked at the hip" to debt sustainability
By Paul Carrel and Leika Kihara
FRANKFURT/WASHINGTON, March 14 Meeting students
at the University of Amsterdam in April last year, European
Central Bank President Mario Draghi extolled the virtues of
courage, recalling a story his father had told him:
"In between the wars, he saw an inscription on a German
monument, a German statue saying that 'if you lose your money
you've lost nothing, because with a good business you will take
it back; if you lose honour, you've lost a lot, but with good
heroic action you can get it back; but if you've lost courage,
you've lost everything.'"
Draghi showed his steeliness at the height of the euro zone
crisis, vowing to do "whatever it takes" to save the currency.
Now investors would like him to show the same mettle again
and take bold policy action to buoy the euro zone economy and
steer it away from the economic quicksand of deflation. With no
'shock and awe' policy move in sight, they may be disappointed.
Draghi has shelved one bite-sized measure the ECB had
discussed, essentially thinning its armoury to a "big bazooka" -
U.S.-style quantitative easing that would be difficult for some
ECB policymakers to stomach - or nothing.
The risk is that the ECB fails to act early and aggressively
enough, and that a cocktail of downward cost pressures sucks the
economy into a quagmire of falling prices.
So far, the ECB insists inflation expectations are sound, or
"anchored" in central bank parlance, and there is no risk of
deflation, which would lead households to defer purchases,
crimping demand and entrenching a downward price spiral.
But the situation is fragile and could change quickly.
"You should not be over-reassured by the fact that
expectations are still anchored, and I would add that when you
find out that they are not anchored any more it may be too
late," said Francesco Papadia, a former director general for
market operations at the ECB.
The example of Japan, which has been mired in deflation for
15 years, offers a frightening precedent. Price declines there
were so mild to start with it took a long time for the Bank of
Japan to acknowledge that deflation had set in and that it was
dangerous enough to require a strong policy response.
JAPAN'S "LOST DECADES"
There are striking parallels between 1990s Japan and the
euro zone's plight now: weak bank lending, fragile economic
growth, a rising exchange rate, and the central bank's
insistence that deflation is not on the horizon.
ECB Executive Board member Benoit Coeure, who speaks
Japanese and knows the country well, warned on Thursday about
banks rolling over bad loans, what he called "zombie lending",
as they had done in Japan. "We've seen a risk of Japanification
of the euro zone," he said in Paris.
There are some differences between the economies: with an
ECB-led health check of its banking sector, the euro zone is
being more proactive than Japan in cleaning up its banks. And
there is no sign yet of European consumers deferring purchases.
"The situation in the euro area is different because
inflation expectations are firmly anchored, whereas they were
not in Japan," Draghi explained after the ECB's March 6 policy
meeting in response to a question from Reuters.
The International Monetary Fund is more concerned and has
urged the Frankfurt-based central bank to take action such as an
interest rate cut or even quantitative easing.
Adam Posen, a former Bank of England policymaker who now
runs the influential Peterson Institute for International
Economics in Washington, also says the ECB should do more.
"Deflation ... doesn't move very much. When it gets low, it
will stay low. We can see now how hard it is for Japan to move
(inflation) up just a couple of percentage points. So the ECB is
accepting too much risk of them getting stuck at where they are
now," he told Reuters.
Draghi himself has warned of the risk of inflation becoming
stuck in a "danger zone" below 1 percent.
ECB staff forecasts released last week showed euro zone
inflation quickening from 0.8 percent last month to 1.5 percent
in 2016, when it would hit 1.7 percent in the final quarter.
That would see inflation just about hit the ECB's target of
"close to but below 2 percent" within its policy-relevant
medium-term horizon. But inflation is notoriously difficult to
forecast over longer periods.
"The experience of Japan is sobering here because nobody
expected that Japan would have some 15 years of inflation
bordering with deflation: our ability to forecast inflation over
the medium-run is poor," said Papadia.
Andrew Bosomworth, a portfolio manager at Pimco, the world's
largest bond fund, says a shock to the euro zone economy could
easily blow the bloc's fragile recovery off course and send it
"Another negative external shock would certainly tip the
scales," he said.
That certainly happened in Japan in 1997, when a toxic mix
of tighter fiscal policy and the Asian financial crisis plunged
the economy into recession and pushed it deeper into deflation.
Emerging market turmoil poses the biggest such risk for the
ECB, with Draghi saying last week that tensions over Ukraine
"could quickly become substantial and generate developments that
are unforeseeable and, potentially, of great consequence".
Such turbulence, coupled with policy inaction from the ECB,
risks further boosting the euro, which hit a 2-1/2 year high
against the dollar after the ECB last week left interest rates
on hold and unveiled no other policy measures.
"The recent appreciation of the euro has had indeed a strong
disinflationary impact," Bank of France chief Christian Noyer
said on Monday, adding that "permanent and deep forces" were
weighing on inflation in the euro zone and wider world.
Other ECB officials share Noyer's concerns and would prefer
a lower exchange rate. Spanish central bank chief Luis Maria
Linde said on Wednesday: "If the euro keeps appreciating against
the dollar, that could lead to additional measures."
ECB policymakers insist they still have policy tools
available if they see a risk of inflation expectations veering
off track. But the realistic range of options is limited, as is
their potential impact.
The ECB's main interest rate is already at a record low of
0.25 percent, and the deposit rate it pays banks for holding
their money overnight is at zero.
A cut in the main rate would likely mean pushing the deposit
rate into negative territory, which would mean charging banks
for parking their deposits at the ECB in the hope they would
instead lend some of the money to firms and consumers.
Some policymakers have reservations about this scenario as
banks could respond by cutting the interest they pay savers. It
could also potentially disrupt the interbank lending market.
A more "bite-sized" option would be for the ECB to stop
operations to soak up money spent on Greek and other countries'
bonds at the height of the euro crisis. This would release some
175 billion euros ($245 billion) into the financial system.
However, Draghi last week played down the benefits of this
technical option for loosening lending conditions, suggesting
the ECB will either do nothing or else take bold policy action
should the outlook deteriorate.
Quantitative easing (QE) - printing money to buy assets -
would be such bold action, and it is a measure some ECB
policymakers have mentioned as an option.
However, hawkish members of the 24-member Governing Council
believe the barriers to embarking on QE are particularly high.
Others are content with the existing policy
stance and see QE as a major shift they would need to look long
and hard at before pulling the trigger.
On a more technical level, some officials also ask whether
U.S.-style QE would have the same impact in the euro zone, where
they see less evidence of a link between interest rates on
sovereign bonds and lending to the private sector.
For now, the ECB argues its 'forward guidance' on rates
remaining low for an extended period creates a de facto
loosening of its policy stance as an expected pick-up in
inflation would bring down real interest rates.
Draghi struck a more dovish tone on Thursday, saying the ECB
would counter any material risk of inflation expectations
becoming unanchored with fresh policy measures, which he said
the bank had been preparing.
But he described deflation risks as "quite limited".
The Japanese experience shows that a defensive approach to
deflation risks can see a major economy come unstuck.
Consumer prices in Japan began to slip in 1999, by 0.3
percent, followed by a 0.7 percent fall in 2000, but it took
until 2001 for the central bank to deploy quantitative easing.
Prices fell 4.1 percent in the 15 years to 2012, an average
of 0.3 percent a year.
The BOJ has long argued that deflation was only a symptom of
a structural malaise such as an ageing population. It also held
doubts on whether flooding markets with cash would push up
prices, a suspicion still shared by some central bankers,
including those at the ECB.
The foot-dragging took its toll.
A prolonged period of sticky deflation sapped Japan's
economic strength by encouraging companies and households to
hold on to cash rather than invest. Japanese firms are still
sitting on 230 trillion yen ($2.25 trillion) in cash, nearly
half the size of the country's economy.
Cyclical booms in the economy didn't last long enough to
change the public's perception that prices would continue to
fall, making deflation self-fulfilling.
"The ECB is wrong, making much the same mistake the BOJ used
to make, which is to assume that everything is a structural
problem, that nothing is cyclical and that you're doomed to low
growth and therefore any monetary expansion will be rapidly
inflationary," said Posen.
Japanese officials are dispensing advice on how to counter
deflation. Finance Minister Taro Aso shared Japan's experience
with his peers at last month's G20 finance leaders' meeting in
"I told them it's very important to take aggressive
macro-policy steps to prevent slipping into deflation," he said.
The IMF is also studying what lessons can be drawn from
Japan's deflation experience to help the euro zone.
Reza Moghadam, the head of the IMF's European Department
said in a recent blog that very low inflation "is working to the
detriment of recovery in the euro area, especially in the more
fragile countries, where it is thwarting efforts to reduce debt,
regain competitiveness and tackle unemployment".
TOKYO ON THE TIBER?
The deflation debate is particularly relevant to countries
on the euro zone periphery that are struggling to reduce their
debts. Greece is already running a negative inflation rate.
But the problem is perhaps biggest for Italy, the euro
zone's third-largest economy, which is saddled with 2 trillion
euros ($2.8 trillion) of public debt and is struggling with the
competing need both to cut costs and spark growth.
Deflation risk is "linked at the hip to debt
sustainability", said Pimco's Bosomworth, adding: "Italy is in a
much better position than Japan, but it's got Japan-style
demographics and debt dynamics evolving in slow motion."
The European Commission expects Italy's debt to hit 134
percent of gross domestic product (GDP) this year.
The attached graphic shows that even with a solid recovery
and higher inflation, Italy will take years to cut its debt to
100 percent of GDP, let alone reach an EU target of 60 percent.
Downward pressure on wages risks lowering inflation, slowing
the erosion of Italy's debt pile.
"If Italy does the same sort of internal devaluation that
Spain, Ireland, Greece and Portugal have done, then euro zone
aggregate inflation is going lower," said Bosomworth. "Europe is
very much on a knife edge."
The risk is that inflation expectations swing lower and
consumers start deferring purchases. Draghi's predecessor as ECB
president, Jean-Claude Trichet, said that is not happening.
"But this does not mean that you do not have to be very
careful," Trichet added.