Deflation looms as next challenge on horizon

FRANKFURT/WASHINGTON (Reuters) - With recession now a reality in major economies from Japan to Germany, policymakers are starting to fret about the chance of a phenomenon many see as even more deadly: deflation.

Japan's decade-long battle with steadily falling prices and economic stagnation looms large in officials' memories and central banks and governments are determined to avoid past mistakes.

"Deflation is probably the worst case for the financial sector because it is very difficult to overcome. Therefore all central banks are going to do everything to avoid it," European Central Bank policymaker Ewald Nowotny said on Nov. 10.

The prospect of constantly falling prices is particularly unwelcome at present given the blow it deals to efforts by banks, firms and households to cut debt and help weather the economic storm now following the financial market crisis.

Central banks, faced with a sudden collapse in growth as well as inflation, have already slashed interest rates and are expected to keep doing so, although economists warn they may run out of rope before prices hit rock-bottom.

"Monetary policy is less powerful on the way down than on the way up," said Stefan Gerlach, professor at the Goethe University of Frankfurt's House of Finance.

"When inflation is rising central banks can raise rates as high as they like, but in the other direction, there's a bound of zero."

The U.S. Federal Reserve has already cut rates to 1 percent, while the Bank of Japan's key overnight rate stands at just 0.3 percent. The ECB, with official rates at 3.25 percent, and the Bank of England at 3 percent have somewhat more room to move.

After hitting historic highs just a few months ago, inflation is falling in all industrialised economies on the back of faltering growth and a sharp drop in energy and food prices. Oil has lost about two-thirds of its value since a peak above $147 in July, to trade around $53 per barrel .

U.S. consumer prices plummeted at their sharpest rate on record in October, fanning fears of a deflationary spiral of falling prices, spending and wages if demand does not pick up.

Fed policymakers have played down the risk of deflation -- which goes beyond a temporary period of negative inflation -- as have their colleagues at the ECB, although BoE Governor Mervyn King has said he cannot rule out deflation in the UK.


"HOLE IN THE HEAD"

Another effect of falling prices is to increase the burden of any given amount of debt, even as banks and households are sharply paring debt, or deleveraging, in reaction to financial turmoil and a wave of bad economic news.

"The problem with negative inflation is that the real value of your debts is increasing," Societe Generale economist James Nixon said.

"In a deleveraging cycle you need negative inflation like you need a hole in the head."

In the United States, the credit crisis and the abrupt deceleration of the economy since mid-September are a one-two punch that make it harder for authorities to shield the economy from deep recession and heal credit markets.

But even so, deflation would be problematic because, if sustained, it could lead consumers and business to curb spending further, shrinking economic activity and reducing demand even more, and pushing prices lower still.

"Once you get into a period of deflation, it's important to get the economy turned around as soon as possible," said Lyle Gramley, a former Fed governor now an analyst with the Stanford Group in Washington.

Gramley said there was some evidence that the combination of rate cuts and Treasury actions to offer hundreds of billions in loans to restore confidence and revive lending was working, but interest rates alone were not enough.

"In a credit crunch such as we are in now, the Fed can lower the Fed funds rate, but if it doesn't succeed in bringing down important private rates of interest or improving credit availability, or pushing stock markets up, then it is, to use the very trite phrase, almost pushing on a string," Gramley said.

Fed Chairman Ben Bernanke laid out the dangers of deflation in a speech in July 2003 when he was a Fed governor.

If official rates were already near zero and prices were falling, deflation could get worse as the weak economy led to more cuts to wages and prices, and pushed up the inflation-adjusted cost of funds.

"Because the short-term nominal interest rate cannot be reduced further, worsening deflation would raise the real short-term interest rate, effectively tightening monetary policy," Bernanke said at the time.

Societe Generale's Nixon said if deflation did become entrenched, central banks might be called on to print money -- effectively, finance government spending by taking public debt onto their balance sheets.

"It would be a reversal of the last 20 years of monetary policy orthodoxy," he said. "But if we do face a 1930s-style recession, that's the way we see the policy response going."