Deflation looms as next challenge on horizon

By Krista Hughes and Mark Felsenthal-Analysis

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 November 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.