GO
Loading...

Is the euro zone at risk of Japan style deflation?

UK shoppers carry Topshop bags on Oxford Street in London, England.
Scott Barbour | Getty Images News
UK shoppers carry Topshop bags on Oxford Street in London, England.

As inflation in the euro zone languishes at its lowest level in four years, some analysts argue that the region is at risk of a Japan-style deflationary rut.

In October, the euro zone's inflation reading came in at 0.7 percent on year, down from September's 1.1 percent and a four-year low. Core consumer prices in Japan, which include oil but strip out volatile food prices, rose 0.7 percent in year to September with a broader measure rising 1.1 percent.

(Read More: Is Japan finally defeating its deflation demons?)

Japan, the world's third biggest economy, has been plagued by deflation for almost two decades and inflation has only recently started to edge higher following aggressive monetary stimulus from the Bank of Japan.

Worries over low inflation levels prompted the European Central Bank to cut its benchmark interest rate by 25 basis points on Thursday.

"Policymakers in Europe are pressured to act because they do not want Europe to become the next Japan," said Kathy Lien, managing director of foreign exchange strategy for BK Asset Management.

(Read More: Japan tax break aims to lure Mrs. Watanabe from deflationary bunker)

"With consumer price growth slowing and producer prices in negative territory, deflation is becoming a growing risk for the euro zone," she added.

The euro zone economy has showed signs of picking up this year after it posted 0.3 percent growth in the second quarter, emerging from its longest recession in 40 years.

But according to Lien, ongoing sluggish growth, particularly in peripheral economies, has made deflation a serious risk. The euro zone's peripheral economies include Spain, Italy, Greece and Portugal, for example.

(Read More: Euro zone unemployment stuck at record high)

Martin Schulz, a senior economist at the Fujitsu Research Institute, added: "After the financial crisis [in Japan], banks had to restructure and cut assets, reducing credit to corporations, which affected their balance sheets negatively. Corporations had to cut costs and restructure."

"When corporations have to cut costs simultaneously they create deflation from the real side of the economy. This is what is happening in Europe's South, and it's what the ECB has to fight," he said.

Don't forget demographics

Other analysts drew parallels between the demographics of the euro zone and Japan at the start of its deflationary period.

"There are certainly parallels between Japan and Europe in terms of demographics," said Frederic Neumann, co-head of Asia economics and managing director at HSBC.

Neumann said the trigger for Japan's deflationary phase was when its working-age population began to shrink in 1997. He said that some countries in Europe are now in the same position.

(Read More: Why the euro area remains a good investment bet )

But Neumann added that there were clear differences between Europe and Japan's inflationary outlooks, arguing that Japan's demographic and indebtedness issues were far more entrenched than the euro zone's.

"Europe doesn't face as big a problem with its private debt as Japan … Comparisons can be drawn between Japan and some of the more peripheral euro zone countries but not all of them," he said.

"Germany, for example, does not suffer from excessive levels of private debt along with some of the other northern countries. This is a key difference from Japan, which, in addition to its demographic headwinds also faced severe pressures for private sector deleveraging in the 1990s," he added.

Neumann said deflationary pressures were not a problem exclusive to Europe or Japan, but to the world over, pointing to the U.S., where inflation was an annualized 1.2 percent in September, down from 1.5 percent in August, and 2 percent in July.

(Read More: EU cuts euro zone growth forecasts for 2014)

— By CNBC's Katie Holliday: Follow her on Twitter @hollidaykatie