Eurozone prices fall, raising spectre of deflation

(BRUSSELS) - Consumer prices in the 16 euro countries fell in June for the first time on record, an official EU estimate showed on Tuesday, raising the spectre of deflation gripping the bloc's recession-hit economy.

The European Union's Eurostat data agency estimated that 12-month inflation in the eurozone fell by 0.1 percent, the lowest rate on records going back to 1996 and down from 0.0 percent in May.

After hitting a record high point of 4.0 percent in June and July 2008, eurozone inflation has fallen sharply as oil and other commodity prices have collapsed in the face of a dire economic downturn.

Most economists had expected that eurozone inflation would dip briefly into negative territory but have ruled out a longer Japanese-like bout of deflation, a pernicious downward spiral in prices.

While the prospect of falling prices may delight consumers, deflation can wreak havoc on the broader economy as households put off purchases in hope of getting a better bargain in the future, cutting into company's profits.

"While commodity price developments remain the wildcard for the inflation outlook, there are plenty of reasons to believe that the annual decline of 0.1 percent in June is just the beginning of a downward trend," said Daniele Antonucci at consultants Capital Economics.

"At this stage, we expect negative inflation rates for the next six months or so."

Commerzbank economist Rainer Guntermann forecast that the eurozone's encounter with deflation would prove short-lived although inflation would likely remain weak for some time in light of the slack in the economy.

"The trough in inflation could be reached already in July which would make falling consumer prices a short-term phenomenon," he said.

The drop in consumer prices puts further pressure on the European Central Bank which tries to keep annual inflation within a comfort zone that it defines as close to but less than 2.0 percent.

"Deflation in June will be no surprise to the ECB, but the bank needs to be on its guard that it does not become established," said economist Howard Archer at consultants IHS Global Insight.

The ECB is widely expected to leave its main interest rate steady at 1.0 percent when it meets in Luxembourg on Thursday.

So far ECB officials have indicated that they do not see a threat of prolonged deflation ravaging the eurozone economy, which the central bank estimates will contract 4.6 percent this year in Europe's worst post-war recession.

"Overall, the current weakness in real economic activity would be expected to dampen inflationary pressures in the euro area but not to lead to outright deflation," ECB board member Lorenzo Bini Smaghi said last week.

"The approach underscores that while economic slack may contribute to movements of inflation in the short run, well-anchored inflation expectations are a crucial determinant in the inflation process.

Further details - Eurostat