Why Europe is worried about the "d" word
With consumer prices falling across Europe, it's sparking fears of an unpleasant type of economic withering: Deflation.
Consumer prices in the eurozone fell 0.2 percent in December, marking the lowest rate since Sept. 2009, Eurostat said on Friday. Negative annual rates were recorded in 16 eurozone countries, including Spain, Italy and Ireland, the European Union's statistical office said.
The decline raises concerns that Europe could slide into deflation, a particularly noxious economic state that saps the value of assets, weakens labor markets, and discourages consumers from spending as they hold out hope for lower prices in the future. One only has to look to Japan's two-decade struggle to emerge from the shadow of deflation to understand why economists and policy makers are so concerned: Its "lost decade" lead to an atrophying economy, including a tougher job market for young workers and declining real wages.
"You certainly don't want deflation to take hold," Gus Faucher, senior economist at PNC Financial Services Group, told CBS MoneyWatch. "The risks are you get trapped in the deflationary cycle, so you want to be very aggressive to avoid deflation."
While a decline in consumer prices doesn't automatically trigger deflation, it does raise the risk, which is why European policy makers and economists are so concerned. The European Central Bank is likely to begin a quantitative easing program in response, possibly as soon as this month, wrote IHS Global Insight economist Howard Archer in a Friday research note.
One of the triggers for Europe's decline in consumer prices last month was the sharp plunge in oil prices, Faucher noted. But if one strips out the sharply lower energy costs in Europe, other prices rose in December, such as food costs.
Lower energy prices also led to a decline in consumer prices in the U.S., with the Labor Department noting on Friday that the consumer price index fell 0.4 percent in December. Fears of deflation are higher in Europe because its overall inflation rate has been lower than in the U.S., which gives the eurozone less of a buffer.
For many American workers, the decline in prices is a welcome break, especially given that many are suffering from stagnant wages. Lower prices at the gas pump are putting real dollars back into consumers' pockets, which should boost spending on other products.
While Europe is concerned about deflation, the longer-term impact in the U.S. is that inflation this year may be lower than the Federal Reserve's target of 2 percent. PNC, for one, is forecasting that core inflation will be 1.6 percent this year, down from 1.8 percent in 2014. Still, the decline may not push off the Federal Reserve from raising rates later this year, especially given a stronger U.S. economy, according to Capital Economics.
"With the activity outlook strong and improving, it makes more sense for the Fed to 'look through' a temporary bout of headline deflation and raise rates, most probably by June," Capital Economics senior U.S. economist Paul Dales wrote in a research note.
As for Europe, its central bank is "rightly concerned" that the potential for deflation exists, Faucher said.
"We expect them to undertake their own quantitative easing, and that will be positive," he said. "They do recognize that while the likelihood of deflation is low, the ramifications are so severe that they are taking steps."