May 29 (Reuters) - Euro zone annual inflation slowed to zero in May and is expected to turn negative in mid-year, raising the possibility of deflation that could derail an economic recovery.
The European Central Bank, which wants annual price growth to be just below 2 percent, expects the price falls to be short-term and therefore not to constitute deflation.
* WHAT IS DEFLATION?
-- Deflation is a prolonged and widespread decline in prices that causes consumers and businesses to curb spending as they wait for costs to fall further. It is the opposite of inflation, when prices rise, and should not be confused with disinflation, which merely describes a slowdown in the rate of inflation.
-- Deflation occurs when an economy's annual headline inflation indicator -- typically the consumer price index -- stays in negative territory.
* WHY IS IT A PROBLEM?
-- As Japan found in the late 1990s and early this decade, deflation is hard to shake off because it is self-reinforcing. Put simply, unless it is stopped early, deflation can breed deflation, leading to what is known as a deflationary spiral.
-- When an economy has fallen into deflation, demand from businesses and consumers to buy products dries up because they expect to pay less later as prices fall. As producers struggle to sell and go bust, unemployment rises, reducing demand further. That causes deflation to become more pronounced.
-- As prices fall, the value of money increases. This makes it more expensive to service existing debts. This is as true for governments, which have borrowed trillions of dollars globally to prop up the financial sector, as it is for consumers.
-- As debt becomes more expensive to pay off, the risk of default and bankruptcy rises, making banks more wary of lending. This reduces demand and further exacerbates the deflationary problem.
* HOW HAS IT BEEN TACKLED IN THE PAST?
-- Tax cuts to boost demand from consumers and businesses
-- Lowering central bank interest rates to encourage economic activity
-- Printing more currency to boost money supply
-- Capital injections into the banking system
-- Increasing government spending on projects that boost returns on private investment
* IN WHICH COUNTRIES ARE PRICES FALLING Y/Y
- Spain (-0.8 percent in May, -0.2 percent in April)
- Belgium (-0.4 percent in May)
- Germany is on the brink - no y/y change in prices in May
* INFLATION EXPECTATIONS
- Monthly consumer surveys by the European Commission show inflation expectations 12 months ahead were negative for the second month in a row in May. The medium term, over which the ECB wants to anchor inflation expectations at its price stability target, is, however, 18-24 months.
* THE ECB VIEW
The bank says on its website that:
"Inflation rates of below, but close to, 2 percent ... underline the ECB's commitment to provide an adequate margin to avoid the risks of deflation.
"Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero.
"In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation."
* JUERGEN STARK, MEMBER OF THE ECB'S EXECUTIVE BOARD, IN MARCH 9 SPEECH:
"Let me emphasise that sharp fluctuations in annual inflation rates or the temporary emergence of negative inflation rates is a normal concomitant of any disinflation process, which by its very nature is temporary and thus should not be confused with another 'd'-word, namely deflation.
"From a conceptual point of view, deflation is a completely different state."
"A deflationary process is a persistent, broad-based and self-sustaining decline in the overall price level. It is reinforced by the anticipation that prices will decline further in the future.
"As a consequence, inflation expectations become unanchored and negative, with adverse effects on investment and consumption.
"By contrast, disinflation, which is linked to transitory movements in relative prices, is per se a welcome development because it helps sustain real incomes, provided that medium-term inflation expectations remain well anchored at levels consistent with price stability.
"To the extent that this is the case, short-term volatility in annual inflation rates, including negative inflation rates, is not relevant from the medium-term perspective of monetary policy.
"We expect that price stability is maintained at the medium term. Moreover, available information indicates that medium-term inflation expectations in the euro area are solidly anchored at levels consistent with the aim of the Governing Council of keeping inflation at (a) rate of below, but close to, 2 percent over the medium term."
Sources: Reuters/World Bank/IMF (Writing by Carl Bagh, Editorial Reference Unit Bangalore, and Jan Strupczewski in Brussels; Editing by Dale Hudson)