Deflation bell tolls for Irish economy

Bloomberg

None of the customers who come into Dublin’s Kingsbury Furniture these days expect to pay full price.

"When people buy something, they say, ’This isn’t going to be cheaper in a couple of weeks, is it?’" said Jimmy Owens, manager of the store in the Irish capital’s Tallaght district.

Ireland, struggling with a ballooning budget deficit and record unemployment, has been at the vanguard of Europe’s economic collapse. Now deflation threatens to push the country deeper into its worst recession in eight decades.

With inflation grinding to a halt in the euro region, Ireland may serve as a test case for policy makers, forcing the European Central Bank to accept falling prices as a serious problem.

"The scale of the shock hitting the Irish economy is massive, but it gives the heads-up for the dynamics we should expect to see for other eurozone countries," said Ken Wattret, chief euro-region economist at BNP Paribas in London. There’s a "significant risk of a prolonged deflation."

Ireland’s consumer prices fell 0.7 percent in March, the first drop since 1999. Households are cutting spending at a record pace, and banks are choking off lending.

A lost decade?

The risk is that consumers will start to anticipate a prolonged period of declines and retrench, pushing Europe into a crisis similar to the one that paralyzed Japan in the 1990s during its "lost decade."

As central banks including the Federal Reserve and Bank of England pump money into their economies through purchases of government securities such as bonds to stave off deflation, ECB policy makers are split on how to respond. Governing Council member Axel Weber, president of Germany’s Bundesbank, has said he doesn’t favor such purchases or cuts in the benchmark interest rate much below the current 1.25 percent. His colleague, Athanasios Orphanides, head of the Greek Cypriot central bank, supports a debate on both options. On April 14, he said the "risk of deflation has increased somewhat."

On April 3, President Jean-Claude Trichet said consumer price indexes "could be negative in the months to come before going up again" in the second half of the year.

"The ECB is still too sanguine about deflation risks," said James Nixon, an economist at Societe Generale in London. By the second half, "council members are going to face quite significant problems and will have to start contemplating purchases of assets to boost money supply."

At its April 2 meeting, the central bank delayed a decision on new measures until its next meeting, on May 7.

"You just wonder whether the ECB has been on top of the game," said Alan McQuaid, chief economist at Bloxham Stockbrokers in Dublin. "Deflation is certainly a bigger headache than inflation, and that’s the last thing the Irish economy needs right now."

Collapse of the tiger
Ireland may be particularly vulnerable after its "Celtic Tiger" economy collapsed in 2008 following the credit crisis. Gross domestic product will probably shrink almost 8 percent this year, the government forecast, more than twice the pace projected for the entire euro region.

Retail sales dropped 20 percent in January, the most since the data were first published in 1974, and unemployment claims surged to a record 372,800 last month, as firms cut jobs.

Karsten Junius, a senior economist at Dekabank in Frankfurt, said a temporary bout of deflation may have a positive impact after the soaring prices - particularly for property - during the country’s 14-year economic boom.

"Ireland is halfway into deflation and facing the biggest economic shock" in the eurozone, he said. "But the economy needs to lower prices in order to regain competitiveness."

On Grafton Street, Dublin’s main shopping thoroughfare, luxury department store Brown Thomas is offering shoppers 20 percent off on goods ranging from handbags to kitchen supplies in a ’Blow the Budget’ sale.

"It’s not enough; it would have to be 50 percent off," said Veronica Kavanagh, a housewife from Dublin, as she walked out of the store.

Kingsbury Furniture’s Jimmy Owens said he’s cutting prices more now than in almost two decades."If I was giving it away for free, they would ask me for money," he said.