February 29, 2016 / 10:06 AM / 2 years ago

Euro zone dips into deflation, raising heat on ECB

BRUSSELS/FRANKFURT (Reuters) - Prices in the euro zone fell in February, falling short of already depressed expectations and virtually ensuring another round of policy easing from the European Central Bank on March 10.

Combined with weak sentiment and output data, the dismal inflation figures suggest that the bloc’s tepid growth is slowing, adding to calls for fiscal and monetary policy action to prop up an economy that has yet to grow back to its pre-crisis size.

“Deflation would be a disaster for the euro area as the burden of high debt would increase,” Nordea economist Holger Sandte said. “Therefore, the ECB will continue easing monetary policy significantly.”

“But no matter what the ECB decides to do on 10 March, inflation is likely to hover around zero during the next few months before it picks up – if oil prices behave well,” Sandte added.

Headline inflation, the key indicator watched by the ECB, fell to -0.2 percent from 0.3 percent a month earlier, far from the bank’s target of close to 2 percent and below already muted expectations for unchanged prices.

More alarmingly for the ECB, core inflation excluding volatile food and energy prices, dipped to 0.8 percent from 1 percent, suggesting that low oil prices are feeding into the price of other goods and services, creating a so-called second round effect that could entrench low inflation and lead to deflation.

Indeed, Bank of France Governor Francois Villeroy de Galhau, an influential member of the ECB’s Governing Council, warned over the weekend that the central bank would have to act if the low energy prices appeared to have long-term effects.

The worrisome inflation print comes just days after the G20 meeting of the world’s top economies warned that leaders needed to looks beyond ultra-low interest rates and printing money to shake the global economy out of its torpor.

Still, the meeting failed to outline any bold steps and even called on central banks to maintain accommodating policies as weak Chinese growth weighs on all top economies and low commodity prices raise the spectre of deflation.

European Union flags flutter outside the European Commission headquarters in Brussels, Belgium, June 4, 2015. REUTERS/Francois Lenoir

FEW TOOLS LEFT

”The inflation data puts more pressure on them to do something. Unfortunately, the number of instruments for them is not increasing.” David Kohl, an economist at Julius Baer, said

“Can the ECB do something about it? Not much, or probably not,” Kohl said, referring to the limited range of tools still left to the ECB after cutting rates into negative territory and venturing into unconventional policies.

The ECB is expected to cut its deposit rate by 10 basis points to -0.4 percent in March, charging banks even more to park their cash overnight, and investors also expect the bank to beef up it 1.5 trillion euro (1.18 trillion pound) asset purchase programme.

Although consumer spending, virtually the only engine of growth, is holding up relatively well, an array of weak business sentiment surveys and poor PMI data indicate that the 19-member currency bloc is increasingly suffering from the emerging markets slowdown.

The European Commission reported on Friday that overall euro zone economic sentiment deteriorated by far more than expected in February, falling to 103.8, just above the long-term average, from a slightly upwardly revised 105.1 in January.

The consumer confidence index, meanwhile, dropped to -8.8 from -6.3 in January, down from -5.7 in December - a poor harbinger for future spending, last year’s bright spot

The ECB is also likely to fret over falling share prices, especially in the case of banks, as market volatility could increase the cost of capital for lenders, holding back credit and essentially reversing the effect of quantitative easing.

The ECB is already buying assets to the tune of 60 billion euros ($65.5 billion), hoping to boost lending, growth and prices but it has acknowledged that its inflation forecasts would have to be cut and its policies reviewed in March given that inflation will not return to target for several more years.

Indeed, euro zone long-term inflation expectations - as measured by the five-year, five-year euro zone breakeven forward EUIL5YF5Y=R - are at record lows below 1.4 percent, suggesting that markets lack confidence in the ECB’s ability to fulfil its mandate.

Additional reporting by Jeremy Gaunt and Francesco Canepa; Editing by Jeremy Gaunt

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