Could deflation hit Europe?

As the U.S. economy picks up and the Federal Reserve Board pulls back on its economic stimulus, the rest of the world continues to struggle with weakness.

The Wall Street Journal’s Stephen Fidler had this story:

Anxieties are rising in the euro zone that deflation—the phenomenon of persistent falling prices across the economy that blighted the lives of millions in the 1930s—may be starting to take root as it did in Japan in the mid-1990s. “Deflation: the hidden threat,” ran a headline emblazoned across a December research note by economists at HSBC.

At last count, prices are falling only in Latvia, Greece and Cyprus. And most forecasters, including those at HSBC, see low inflation as more likely than deflation on average in the euro zone.

But inflation is stubbornly low, under 1% on average across the 18-nation bloc, despite the money that the European Central Bank has been pumping into the economy with the aim of spurring investment and growth, actions that often push up inflation. That is way under the ECB target of “below, but close to 2%,” and, if the average is below 1%, more economies using the euro are at risk of deflation.

Why worry? If economies cope with inflation, why not with deflation? For centuries until World War II, capitalist economies experienced periods of severe deflation interspersed with spells of inflation and continued on a path of long-term growth.

Ian Wishart and Kristian Siedenburg wrote for Bloomberg Businessweek that leaders in Europe were struggling to find a way to help the economy grow:

European Union leaders pondering the fruits of a 120 billion-euro ($163 billion) push to jump-start the economy and create jobs can look to data this week for evidence of how little has been achieved.

The euro-area unemployment rate probably held near a record in November at 12.1 percent, according to the median estimate in a Bloomberg News survey of economists. That report on Jan. 8 follows tomorrow’s release of December consumer-price data. Analysts see inflation hovering near the four-year low that preceded a surprise interest-rate cut a month earlier by the European Central Bank.

In December, EU leaders acknowledged their struggle to create jobs, 18 months after they unveiled the Compact for Growth and Jobs, saying unemployment remains “unacceptably high.” Governments are relying for continued support from the ECB, which may this week repeat its vow to keep its policy accomodative for “as long as necessary.”

“Unemployment is bound to remain high amid a sluggish recovery,” said Tobias Blattner, senior economist at Bank of America (BAC:US)Merrill Lynch in (MER:US)London. “And with credit remaining scarce and expensive in large parts of the euro area, inflation will fail to creep higher. Deflation fears, however, are unlikely to materialize.”

With the euro-zone economy battered by the debt crisis and slow to shake off a record-long recession, policy makers are struggling to find a recipe for growth. The ECB estimates that the euro-area economy contracted 0.4 percent in 2013 and will expand 1.1 percent this year.

Bloomberg’s Kasia Klimasinska reported Jan. 3 that even U.S. officials are trying to help Europe avoid deflation and shore up the monetary policy:

U.S. Treasury Secretary Jacob J. Lew will urge European officials next week to pursue policies that boost economic growth, avoid deflation and strengthen the banking system, a Treasury official said today.

Euro-area domestic demand remains below its 2009 level when measured in real terms, and the unemployment rate is the highest in at least 20 years, the official, speaking on condition of not being further identified, told reporters on a conference call. Lew departs Jan. 6 on his fourth visit to Europe since he took office in February 2013.

Lew is scheduled to meet with French President Francois Hollande and Finance MinisterPierre Moscovici on Jan. 7. On Jan. 8 he will meet with German Finance Minister Wolfgang Schaeuble in Berlin before traveling to Lisbon later that day for talks with Portuguese government officials.

Szu Ping Chan wrote Dec. 28 in the U.K. Telegraph that Europe’s lack of action was pushing it toward deflation:

The eurozone is “sleepwalking” its way towards a Japanese-style deflationary trap that could last decades, the world’s largest bond fund has warned.

The Pacific Investment Management Company (PIMCO) said deflation posed the biggest threat to the single currency bloc in 2014. A stubbornly strong euro together with painfully slow reforms and a “paucity of ambition” threatened to push the bloc’s already low inflation rate into negative territory, the fund said.

“The demographics in large parts of Europe aren’t great,” said Mike Amey, portfolio manager and managing director at PIMCO.

“Even now, success in Europe is defined by 12pc unemployment and a growth rate of between zero and 1pc. If that’s success, they are at risk of slipping into deflation just because they’re willing to tolerate these economic conditions.”

Deflation poses a threat to economies, because if prices are falling people put off spending in anticipation of further falls. Retailers are forced to slash prices, which leads to declining profits, lower wages and people struggling to meet fixed loan repayments because of falling salaries.

While it experts disagree whether Europe will actually slip into full deflation or stay at extremely low inflation rates, it’s still a bit troubling that European policy makers don’t seem to be moving quickly to provide stimulus. Money managers will be watching closely to see what the economy will do and how it will impact their portfolios.