Deflation hits Europe

A year ago, everyone was saying that the eurozone was "only one shock" away from European deflation, says the Financial Times' Wolfgang Munchau. "Since then we have had two."

Russia's invasion of Ukraine, and the sanctions that followed, hit demand and growth. Meanwhile, oil prices have collapsed, reducing prices further. In December, the annual rate of consumer price inflation (CPI) in the eurozone fell to -0.2% from 0.3% the previous month. Deflation has arrived.

The descent into deflation is due to the oil price, as Capital Economics points out. If it doesn't soon change course, energy effects alone will push deflation below -1% this spring and keep it there for most of 2015.

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What's more worrying, however, is that core, or underlying inflation (which excludes volatile food and energy prices) is weak a mere 0.8% and is set to fall, given the "near-stagnant" economy. Industrial production slid again in Germany, France and Spain in November.

That means that spare capacity is rising. Combined with unemployment at a record high 11.5%, the job market is hardly likely to produce any inflationary pressure.

Is European deflationbad?

But when falling prices are largely down to weak domestic demand, it can become entrenched and self-perpetuating, resulting in a slump, such as those seen in the Great Depression in the US. It's particularly troublesome when economies are creaking under the burden of heavy debt loads.

That's because, just as inflation nibbles away at a fixed sum of debt, deflation does the opposite. It makes the debt burden heavier as the real (inflation-adjusted) value rises. That makes indebted households reluctant to spend and firms reluctant to expand, undermining economic momentum.

Falling prices also hit company profits and deter corporate investment, as potential returns fall. Wage rises moderate, which undermines inflation and expectations of future inflation. As expectations of falling prices become more widespread, all these problems begin to reinforce each other. Demand and growth fall, in turn making deflation worse.

QE to the rescue

European Central Bank (ECB) president Mario Draghi has repeatedly hinted that quantitative easing (QE) injecting printed money into the economy by buying up government bonds, as we have seen in the UK, America and Japan is on its way.

But will it work? "Any plan will have to be spectacular to jolt expectations of inflation and growth upwards," says the FT. Bond yields are already historically low. That leaves little room for a boost to lending via falling long-term interest rates.

Then there's the fragile banks. They are recovering, but it's a slow-moving process, and they may be more reluctant to lend than their UK or US counterparts were during and after QE, because European countries have been slower to recapitalise their banks.

Nor does there seem to be much appetite for borrowing in the eurozone. Europe's "chronic deficiency of demand is turning acute". The upshot is that the ECB may end up "pushing valiantly on what may turn out to be a monetary policy string", concludes the FT.

But as we have often pointed out, QE's impact on economies is always debatable the fact that much of the newly created liquidity ends up in asset markets is not. The money arriving in bond markets encourages investors to buy other assets with the cash.

And Draghi will be aware that he needs to deliver a big QE package to convince markets that he can avoid a deflationary slump a move that fears over a turbulent Greek exit would hasten.