Analysis: Euro zone's queasy feeling as it looks in Japan mirror

Wed Jul 10, 2013 11:45am EDT
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By Alan Wheatley, Global Economics Correspondent

LONDON (Reuters) - Monetary policy that cannot get traction; weak banks that cannot or will not lend; an economy trapped in a twilight world of low growth, haunted by the specter of deflation.

If this combination sounds familiar, that's because it is.

The euro zone, still drowning in debt bequeathed by the great financial crisis, increasingly resembles Japan in the 1990s as it struggled with its own balance sheet recession brought on by the bursting of an almighty asset bubble.

Japan was long viewed with pity for its failure to shake off its torpor. Its central bank was criticized for policy timidity.

Now, though, the tables are turned. While new Bank of Japan Governor Haruhiko Kuroda has embarked on quantitative easing on an unprecedented scale, the European Central Bank is shrinking its balance sheet and contenting itself with ‘forward guidance' to talk interest rates down.

In light of the euro zone's wide output gap, reflected in record high unemployment, and the mountain of debt that governments and the private sector still need to pay down, some economists say inflation risks falling uncomfortably short of the ECB's target of just below 2 percent.

In a new report, JP Morgan said it expects core inflation, excluding taxes, to drop below 1 percent, from 1.1 percent in the 12 months to May, and remain below that level at least until the end of 2015.

The downward pressure on prices is especially great in struggling countries on the euro zone periphery.   Continued...

A woman offers a bag filled with bread to other woman (not pictured) at the Alfama neighbourhood in Lisbon July 3, 2013. REUTERS/Rafael Marchante