Euro zone deflation: Why it matters

The long-feared threat of euro area deflation finally materialized at the end of 2014, data showed on Wednesday.

Consumer prices across the euro zone fell by 0.2 percent year-on-year in December, according to this first official estimate—worse than the 0.1 percent decline forecast, and down from November's 0.3 percent rise.

Maintaining price stability is the European Central Bank (ECB)'s raison d'etre, so the slip into deflation is a challenge to the bank's credibility.
"For a central bank whose sole mandate is to maintain price stability by meeting its inflation target of just below 2 percent, this is a severe blow to the credibility of Europe's monetary guardian," said Nicholas Spiro of Spiro Sovereign Strategy, in a research note on Wednesday.

The news will add to pressure on the ECB and its president, Mario Draghi, to announce a full-blown sovereign bond-purchasing program, known as quantitative easing (QE), at its meeting this month. The aim would be to boost money supply in the hope of promoting lending into the real economy.

"The ECB's hand has been forced. Anything less than a firm pledge by its president, Mario Draghi, that sovereign QE is imminent will be taken very badly by markets," wrote Spiro.

The ECB has already introduced a swathe of "unconventional" stimulus measures, including covered bonds and asset-backed securities (ABS)-purchasing programs, which have failed to see off deflation.

German opposition to QE is seen high and there are concerns the ECB might opt for watered-down version as a result, which could limit its stimulus potential.

For instance, the central bank could opt to only purchase the highest-rated sovereign bonds, in order to limit the risk taken on to its balance sheet.

After Wednesday's data, Capital Economics warned that the euro zone could now face a period of deflation lasting several months, which could imperil countries' efforts to reduce large debt piles. The value of debt is usually fixed in nominal terms, so falling price levels increase the real value of debt.

Deflation could also set off a downward spiral in demand, as consumers hold back on purchases, waiting for prices to fall still further, and companies cut back on investment for fear that future returns will be lower.

On the other hand, deflation can provide a positive economic spur, with falling consumer prices boosting household spending. The risk though is that rather than simply boosting spending powers, falling consumer prices lead to declines in nominal household, business and government incomes. This in turn would increase the burden of servicing public and private debts.