* ECB must pitch QE plans right or risk deflation trap * ECB has two schools of thought on best QE tactics * Labour rigidities can both protect and worsen deflation risk * Deflation still seen as outside bet
By Marc Jones
FRANKFURT, April 17 (Reuters) - The European Central Bank must pitch the unconventional measures it plans to announce in May to boost the economy exactly right or risk being caught in a deflation trap if the fall in euro zone prices takes hold.
Although a damaging downwards price cycle is still seen as an outside bet, the risk is growing -- and evidence that euro zone deflation would be unusually hard to shift once it takes root increases the dangers for the ECB in waiting too long to pull out all the stops to support the economy.
Other major central banks have already started buying up assets with newly-printed money to supplement interest rate cuts, and President Jean-Claude Trichet has promised to lay out the ECB's thoughts on quantitative easing at its May 7 meeting.
However, policymakers appear split between continuing to focus squarely on supplying liquidity to banks or going big and following the U.S. Federal Reserve, Bank of England and Bank of Japan down the route of asset purchases.
Analysts see two clear camps in the bank. The first is led by influential Bundesbank head Axel Weber and ECB Executive Board member Juergen Stark, who favour putting a floor of 1 percent under interest rates and expanding the ECB's current role as the ATM for the euro zone's liquidity-strapped banks.
In the other corner are ECB Vice-President Lucas Papademos, Cyprus's Athanasios Orphanides and Austria's Ewald Nowotny, who think a more radical approach of buying corporate debt from banks might give them the necessary incentive to start large scale lending again.
"What no euro member needs now is to see ECB members playing a game of bowls whilst the enemy - recession - is not only at the door but rife amongst all member states," said Howard Wheeldon, a senior strategist at BGC Partners.
"At the heart of the various internal bickerings lies the difficulty of achieving agreement not only on interest rate movement but also a refinancing package for delivery next month that includes a plan to purchase debt."
While Papademos et al have talked up the potential benefits of buying assets, Weber said this week that direct intervention in markets should take a backseat. Stark has also warned the "helicopter money" being thrown at the financial crisis risks sowing the seeds for future inflation problems.
INFLATION v DEFLATION
Stark's concerns come directly from the economics textbook and lie at the heart of his and Weber's reluctance to start buying assets. History is strewn with evidence that pumping vast quantities of money into an economy leads to damaging inflation, from Germany in the 1920s to Argentina in the late 80s.
But at the opposite end of the spectrum, some economists are growing increasingly concerned that, with no end in sight to the financial turmoil, the ECB is still underestimating the threat of deflation -- a sustained and damaging fall in prices.
Analysts warn that certain characteristics of the euro zone's economy, such as its extensive safety nets for workers, could make it harder for the region to shake off deflation if it did take hold. This compounds the risks if the ECB remains in denial for too long.
"The rhetoric on deflation has been steady all the way through - there is no danger, there is no danger, there is no danger. But from my perspective it is a very real risk. It is not the central view but it is an increasing risk," said Colin Ellis, European Economist at Daiwa Securities.
Euro zone inflation annual plunged to an all-time of 0.6 percent in March and analysts expect it to continue its downward trajectory in the months ahead. Spanish data this week also showed prices there fell for the first time since records began in 1962.
Trichet and other ECB policymakers have acknowledged prices might fall across the euro zone come the middle of the year, but most continue to shrug it off as a blip and not the start of a more damaging deflationary spiral.
Survey data of consumer price expectations suggest they have got it right. Financial market-derived calculations also put inflation at between 1.25 and 1.75 percent for up to nine years out -- lower than the ECB's goal of just under 2 percent, but nowhere near negative.
However, Orphanides, one of the ECB's more outspoken members, this week said the risk of deflation was rising.
INDEXES FINGERED
RBS economist Jacques Cailloux said that while unemployment safety nets, pay deals linked to past inflation and the high upfront cost of firing workers tend to prop incomes and consumer demand early in a downturn, they turn into a hindrance in a longer recession.
"Wage and labour rigidities and social security systems could affect how the euro zone copes with the deflation threat compared to other parts of the world," he said.
"In the short term they (rigidities) act as a buffer against the risk, but in the long term deflation probably has a higher chance of materialising because these rigidities force corporates to adjust staffing levels aggressively."
And once unemployment starts to accelerate, consumers tend to recoil, Cailloux said. Domestic demand then slumps and the risk of a vicious deflationary spiral jumps.
Bank of America analyst Gilles Moec said wage indexation also creates problems. "In 2008, even in countries like Spain that were hit hardest by the recession, wages continued to grow as they kept up with inflation as a consequence of the wage indexation systems."
"But think of the situation in 2010, the inflation that will serve as a basis for wage indexation will probably be negative. So what protected you at the beginning becomes a problem."
Such rigidities appear specific to the euro zone. The ECB estimates that just over a third of workers in the bloc have pay linked to inflation, whereas a recent research paper published by the bank found no signs of indexation in the United States.
One worrying sign is that companies now seem close to the tipping point that Cailloux warns of. Euro zone unemployment jumped more than expected in February to 8.5 percent and the OECD predicts it will reach almost 12 percent in 2010.
Economists say the key to the deflation/inflation question is whether the economy rebounds or worsens in the coming months.
A number of policymakers this week said they see tentative signs of recovery but on the downside, the IMF predicted this recession would be longer and more painful than most.
Analysts also think that if the ECB did start to see a serious chance of deflation, Weber, Stark and their followers would have to abandon their reluctance to buying assets and cutting interest rates below the 1 percent mark.
"If the ECB did start to see deflation they would have to have a rethink (about QE plans)," said Dresdner Kleinwort euro zone economist Rainer Guntermann.
"Maybe policymakers would accelerate the process, move into asset purchases or even bypass the banks altogether. But on the other hand if things started to stabilise then they can afford to keep the focus on the banking sector."
For IMF paper on deflation risks, please see:
http://www.imf.org/external/pubs/ft/spn/2009/spn0901.pdf
For ECB paper on wage bargaining, please see:
http://www.ecb.int/pub/pdf/scpwps/ecbwp974.pdf
For details of ECB staff forecasts for inflation please click
(Reporting by Marc Jones; Editing by Andy Bruce)