Europe weighs bold steps to avoid Japan-like deflation

04/09/2014 3:11 PM

04/09/2014 4:41 PM

Faced with a moribund economy and the risk of Japan-like debilitating deflation, the European Central Bank is weighing unconventional measures to spark economic growth and, oddly enough, to drive up prices.

Europe’s central bank is considering a range of unconventional options because the unemployment rate is in double digits and the rate of inflation _ the rise in prices across the economy _ came in at an annualized 0.5 percent in March.

If it comes in very low again on April 30, it might signal that Europe risks going the way of Japan in the 1990s and facing years of deflation, in which prices, wages and expectations are locked in a downward spiral.

Central banks want a healthy amount of inflation to ensure that the economy maintains forward momentum, but they don’t want too much, which would mean the economy is overheating. The Federal Reserve and many large central banks seek an inflation target between 1 percent and 2 percent.

The head of the European Central Bank, Mario Draghi, is expected to comment more on Europe’s plans this weekend at the spring meetings of the International Monetary Fund and the World Bank in Washington. He’s described internal talks about options as “ample” and “very rich.”

In an interview Wednesday with the CNBC business channel, Treasury Secretary Jacob Lew said Europe needed to do more to stimulate demand and generate economic activity.

“The risk of deflation is something that has a lot of people concerned,” Lew said. “And, you know, the answers lie in, I think, policy decisions that could be taken. That's actually the good news. There are solutions that would help.”

Analysts widely expect Draghi to try asset purchases first, much as the Fed has done with its purchases of trillions of dollars in government and mortgage bonds in order to drive down lending rates and spark economic activity. That controversial effort is called quantitative easing.

“Inflation (in Europe) is falling through 1 percent, and with unemployment at 12 percent there is no prospect it will pick up, and if the economy stumbles deflation is a real threat,” said Mark Zandi, the chief economist for Moody’s Analytics. “This means unconventional monetary policies, and probably quantitative easing via the purchase of covered bonds issued by the banks.”

Covered bonds are similar to mortgage bonds in the United States.

Several European Central Bank officials in recent weeks have also discussed the possibility of negative interest rates, where banks would be penalized for keeping money at the central bank and thus encouraged to lend it for virtually nothing. That would still be better than losing money by keeping reserves at the central bank.

“It’s really pretty unprecedented,” said Paul Sheard, the chief global economist for ratings giant Standard & Poor’s.

That could also drive down the value of the common currency, the euro, helping European nations export more by making their products and services cheaper in the global economy. Imported goods would be more expensive, favoring domestic manufacturers.

The talk in Europe about negative rates might just be an effort to talk down the value of the euro and thus provide a little more economic juice. There was similar talk last year and it had that desired effect.

Not only have none of the three other major central banks tried negative interest rates, the Bank of England, the Bank of Japan and the Fed didn’t even publicly talk about it in any serious way. These central banks, with questionable results, have opted for buying assets _ such as stocks in Japan or government bonds in the case of the Fed _ in order to generate bank reserves that could stimulate economic activity and inflation.

“The idea was that with quantitative easing, banks could take those excess reserves and lend them out . . . and it just hasn’t happened, at least at the pace that was expected,” said Scott Anderson, the chief economist for San Francisco-based Bank of the West.

Europe fears deflation, because consumers and businesses would sit on the sidelines waiting for even lower prices, and wages and purchasing power would fall accordingly. It creates a negative feedback loop in which everyone expects prices to go down further, and it’s hard to break because there’s psychology involved.

“When you look at the slack in the labor market, this is a long-term problem,” Anderson said of high European joblessness, which is 25 percent in some countries, with 50 percent youth unemployment in others, and is holding back inflation. “That’s Depression levels of joblessness. That’s pushing down wages and salaries for those that are employed.”

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