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Europe faces deflation risk

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Legal & General Investment Management’s (LGIM) European Economist Hetal Mehta says there is a real danger of deflation in the euro area, but that no significant action is expected from the European Central Bank (ECB) in the near term…

Euro area consumer price inflation has been on a downward trend since mid-2011. We think this trend is likely to continue as lower unit labour costs and the ongoing structural reforms to liberalise markets, which generate price competiveness, drag down inflationary pressure. “The prolonged period of unemployment in Europe has added to deflationary pressure as lower employment has fed through to lower consumer demand.

The euro has appreciated significantly over the past year, reducing import prices and hence pushing inflation even lower. The combination of these factors means that LGIM is forecasting that core inflation in the euro area will average just 0.5% in 2014 with headline inflation around 1%.

The pain of a period of sustained deflation, or even low inflation, will be felt most acutely by countries with high debt levels – found in ample supply in Europe. Without the ability to inflate away the real value of debt, governments will come under greater pressure to proceed with aggressive austerity which could trigger a vicious spiral of further economic weakness and a renewal in debt sustainability fears.

This leaves the ECB with a conundrum. Unlike the Fed or the Bank of England, the ECB is constrained by the competing interests of the different member states. The ECB ultimately has a choice between preserving the purchasing power of savers in core euro area countries or keeping conditions for periphery sovereigns supportive.

Overall, we think the ECB’s monetary policy response will be limited. A further, small reduction in interest rates is possible, but noteworthy action is only likely on evidence of a prolonged deflationary period or if the growth outlook deteriorates significantly relative to the ECB’s already conservative forecasts.

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