European inflation falls below zero, bolstering stimulus hopes

Theeurozonehas a new economic headache to contend with.

Consumer prices fell in December in the currency bloc for the first time in over five years, raising concerns of a protracted drop that can hurt growth, and reinforcing expectations the European Central Bank will provide an aggressive stimulus.

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Lower energy costs pushed consumer prices 0.2 per cent lower in the month from the year before, according to a report Wednesday by the Eurostat statistics agency. That's a big drop from the 0.3 per cent annual rise in prices recorded in November and the 0.1 per cent drop markets were expecting.

The huge impact of lower oil prices is evident in the fact that the core inflation rate, which excludes volatile items such as food, tobacco and energy, actually rose to 0.8 per cent from 0.7 per cent.

Lower prices may sound good in principle, especially if they are due to a fall in oil prices the euros saved filling up a car for less can be used elsewhere, promoting economic activity. For a region stuttering from one quarter of anemic growth to the next, every little helps.

The problem arises when the fall in prices endures, a situation that is often referred to as a deflationary spiral. That can choke the life out of an economy if consumers put off purchases in the hope of future bargains. It can erode companies' profits and make governments' debts appear greater.

Deflation can also prove difficult to reverse, as evidenced by the case of Japan, whose economy has stagnated for two decades.

Policymakers at the ECB will weigh these factors when they meet next on Jan. 22. Many in the markets think they will be fretting about deflation as the eurozone, which now counts 19 members following Lithuania's adoption of the currency this year, has seen low inflation for months amid subdued growth and high unemployment. Separate figures Wednesday showed unemployment across the eurozone remained at a high 11.5 per cent in November.

Stimulus plan expected

As a result, many economists think the ECB will this month back a stimulus program that involves government bond-buying, something other central banks such as the U.S. Federal Reserve and the Bank of England have done over the past few years. The ECB, after all, doesn't have much left in its arsenal, having already cut interest rates to record lows and backed the purchase of some private-sector bonds.

Expectation for more stimulus has weighed heavily on the euro, which hit a new 9-year low of $1.1815 on Wednesday. Because the stimulus would create new money, traders are selling the currency on the prospect of more euros in circulation.

"The emergence of negative inflation does forcefully raise the spectre of a possible prolonged period of deflation," said James Ashley, chief European economist at RBC Capital Markets. "For those policymakers who, hitherto, might have been undecided over whether or not to take further action immediately, this may be just the clarion call that was required to appreciate the gravity of the situation."

Proponents of QE say the policy can help shore up an economic recovery and support prices by reducing the borrowing costs for businesses, households and governments. The associated fall in the currency could also help boost growth by making exports cheaper and push prices up by making imports more expensive.

But officials in Germany, Europe's largest economy, have said such a program of government bond purchases would amount to throwing money at profligate states. Germans are concerned that the country's taxpayers will end up being burdened with the debts of countries like Greece, Italy and Portugal.

Success is not guaranteed, as evidenced by Japan's return to recession even though the country's central bank is enacting its own bond purchase program.