Low Inflation Tests World's Central Banks

Subdued Prices Persist Despite Years of Easy Money; Deflation Still a Threat

By SUDEEP REDDY in Washington, BRIAN BLACKSTONE in Frankfurt and JASON DOUGLAS in London

The Wall Street Journal

Updated Dec. 17, 2013 7:28 p.m. ET

Inflation is slowing across the developed world despite ultralow interest rates and unprecedented money-printing campaigns, posing a dilemma for the Federal Reserve and other major central banks as they plot their next policy moves.

U.S. consumer prices rose just 1.2% in November from a year earlier, according to Labor Department data released Tuesday. The subdued price data came as the Fed opened a two-day policy meeting at which the fate of its $85 billion-a-month bond-buying program—an effort to hold down long-term interest rates and drive up the value of homes, stocks and other assets—is a central focus.

Meanwhile, annual inflation in the euro zone was 0.9% in November, the European Union's statistics office said Tuesday. And central banks in Sweden and Hungary cut interest rates, the latest efforts elsewhere in Europe to boost struggling economies as inflation remains low.

The downward pressure on prices presents a conundrum for policy makers across advanced economies: Should they respond with even easier monetary policy or dismiss it as a temporary development?

Central bankers worry about inflation falling too low because it raises the risk of deflation, or generally falling prices, a phenomenon that is difficult to combat through monetary policy. Some economists believe weak or falling prices can lead consumers to delay major purchases, exacerbating an economic slowdown. Even without deflation, very low inflation can be a sign of weak demand that weighs on wages, corporate profits and growth.

"We're in a world where there's still a tremendous amount of economic slack," said Joseph Lupton, a global economist at J.P. Morgan Chase. "A return to growth is not a return to health. There's a long way to go here, which is why central banks in places like the U.S., U.K. and Japan are trying to get inflation up."

Inflation in both advanced and emerging economies picked up in the early stages of the economic recovery, eventually straddling central banks' inflation targets closely enough that many policy makers were charting an exit from their extraordinary monetary policies. But persistently weak demand in recent years has pushed inflation back into uncomfortably subdued territory.

While policy makers have fretted about low inflation for years, their actions to combat it have yielded generally disappointing results. In the U.S., the Fed is wrapping up a fifth year of near-zero interest rates while also carrying out trillions of dollars of bond purchases in an effort to spark stronger hiring and investment. Employers are starting to add jobs at a steady pace, though overall economic growth remains modest.

But U.S. inflation has been below the Fed's 2% target for much of the past two years. The central bank's preferred gauge, the price index for personal consumption expenditures, increased just 0.7% in October from a year prior, according to a Commerce Department data released earlier this month.

Fed officials have forecast consistently that inflation would pick up, but that hasn't happened. Whether the Fed announces a pullback in its bond-buying program Wednesday or in coming months, it is expected to acknowledge its concerns about low inflation. That could reinforce expectations that the central bank will keep short-term interest rates near zero for years to come—as investors now widely expect.

The situation in Europe is perhaps more fraught. European Central Bank President Mario Draghi has said the euro currency bloc may see a "prolonged" period of low inflation. ECB forecasts support that view, with inflation averaging just 1.3% in 2015, well below its target of just under 2%.

Mr. Draghi says Europe doesn't face a slide into deflation like the one that plagued the Japanese economy for much of the past two decades. The ECB loosened its monetary policy more decisively than Japan did in the 1990s, he said earlier this month, and it is acting more swiftly to resolve problems with its banks. The ECB last month cut a key interest rate to 0.25% as it highlighted concerns about low inflation.

But the latest consumer-price figures mask deep divisions across the 17-member currency bloc. In healthy economies such as Germany and Austria where unemployment is low, inflation is around 1.5%. But in stressed countries along the bloc's southern periphery, consumer prices are stagnant or falling. Annual inflation was 0.7% in Italy last month and just 0.3% in Spain. The disparity makes combating low inflation broadly across the currency union difficult.

Deflationary forces deepened in recession-ravaged Greece, according to the Eurostat figures, with consumer prices down 2.9% in November from the previous year. Despite a banner year for Greek tourism, which saw visitor arrivals jump double digits to more than 17 million this year, the country's two main carriers, Aegean Air and Olympic Air, are struggling. Both carriers have offered steep discounts to fill vacant seats and their situation is so dire that, in October, the European Commission allowed the two airlines to merge—reversing its earlier ban—so as to save one or both from bankruptcy.

High inflation had been a major headache for the Bank of England in recent years, setting the U.K. apart from many other advanced economies. But inflation weakened in November to its slowest pace in four years, with prices rising just 2.1% during the month from a year earlier. That was just a hair above the Bank of England's 2% target.

Further evidence of subdued inflation was evident in U.K. wholesale prices Tuesday. Prices charged by companies at the factory gate rose 0.8% on the year in November, while raw-material costs fell by 1%.

Inflation's retreat is likely to reinforce the BOE officials' commitment to keep their benchmark interest rate at a historic low of 0.5% to underpin an accelerating U.K. economic recovery. The inflation slowdown puts the BOE "in a more comfortable position as it suggests that as growth picks up it is less likely to be concerned that inflation pressures will build up in the economy," said Blerina Uruci, an economist at Barclays.

Some developing economies, meanwhile, saw inflation accelerate enough that they were worrying about soaring prices. That changed over the past two years as demand slowed.

The slowdown in global prices has helped Brazil fight domestic inflation that peaked in June at a 6.7% annual rate and has since fallen to 5.8%, still above the central bank's 4.5% target. The country's central bank has increased interest rates by 2.5 percentage points, to 10%.

In China, the world's second-largest economy, inflation as measured by consumer prices has fallen to below 3.5% this year from 8% five years ago. Some economists say years of state-directed overinvestment in factories and a buildup of excess capacity could push prices even lower.

While China's low-cost manufacturing helped keep prices of consumer goods down in Western nations in recent years, the huge source of supply today risks exacerbating deflation worries in industrialized countries, some economists say. Excess capacity in key industries such as steel, glass and construction equipment has dragged prices down in some sectors.

China's growth slowdown also has reduced its demand for imports of items such as iron ore, copper and coal, pushing down prices in a range of global commodity markets.

"For a lot of industrial commodities—especially metals—Chinese demand is the factor that causes prices to rise or fall," said Mark Williams, an economist at Capital Economics, a London-based research firm.

Pep Boys, a Philadelphia-based supplier of tires and auto parts, blamed its disappointing financial results last week partly on weaker sales of lower-priced tires. That was "a result of competitive pressures from Asian imported tires," Pep Boys CEO Michael Odell said. He warned that the "pricing pressure could persist."

—David Roman in Madrid and Richard Silk in Beijing, Paulo Trevisani in Brasilia and Alkman Granitsas in Athens contributed to this article.

Write to Sudeep Reddy at sudeep.reddy@wsj.com, Brian Blackstone at brian.blackstone@wsj.com and Jason Douglas at jason.douglas@wsj.com