Euro zone deflation fears may be overblown

Charles Platiau | Reuters

An employee adjusts a discount sign in a department store in Paris, January 6, 2015.

It's official: Inflation in Europe has shifted into reverse. But growing worries about a prolonged, painful bout of deflation may be premature.

The European statistics office confirmed Wednesday that prices in the 18 countries using the euro were 0.2 percent lower in December than a year before, after rising 0.3 percent in November. The last time prices slipped into reverse, in October 2009, the euro zone was in the grip of the global Great Recession.

Read MoreEuro zone slips into deflation, pressure on ECB

Now, as Europe—and much of the rest of the world—slogs through a faltering recovery, there are fears that falling prices in the euro zone's stagnant economy could spark an extended period of deflation, when the consumer prices of finished goods fall over an extended period.

If it takes hold, deflation can be agonizingly difficult to reverse. A downward price spiral could prompt businesses and consumers to cut back on spending and investment, waiting for prices to fall further, setting off an economic contraction that can deepen.

That's why European central bankers are scrambling to avoid that scenario. One widely expected antidote would involve massive bond buying to pump cash in the European banking system and revive spending and lending. The European Central Bank is set to consider such a move at its next meeting Jan. 22.

Read MoreEuro zone deflation: Why it matters

Until then, the price crash has rattled investors. Demand for the safe haven of German bonds was so strong this week, the yields on some issue actually turned negative—meaning investors were willing to lose a little money to avoid the risk of losing more in other investments.

But those worried about deflation may be jumping the gun. There are reasons to believe this initial flirtation with deflation may not be as painful as the economic textbooks warn.

First, most of the downward price pressure is coming from the plunging cost of crude, which has crashed since July as producers have flooded the world with oil. Unlike past price plunges that have prompted cutbacks by OPEC producers, the cartel has vowed to keep pumping.

But Wednesday's euro zone data showed that so-called core inflation, which excludes energy and food prices, was stable at a 0.7 percent annual rate in December—unchanged from the prior two months.

So while overall prices are still rising, businesses and households are getting a break on energy costs. That dividend is largely good news for a global economy struggling to gain momentum.

"There's good deflation and bad deflation," said David Kelly, chief global strategist at J.P. Morgan Funds. "Lower oil prices are a clear positive for the U.S. economy, for the Chinese economy and the European economy. This stimulates the economy's growth; it doesn't depress it."

Read More Ticking time bombs: Where oil's fall is dangerous

It's far from clear how much further prices will fall, and where they'll stabilize in the long run. Kelly is among those who think the oil price swoon is temporary; he expects lower oil prices to spur demand and crimp production, sending prices back up above $80 a barrel in two years.

Earlier this week, Moody's Investors Services said it expected lower profits for oil companies would force them to cut back investment in capital spending on new production.

There's another major offset to European deflation—the weakening euro, which has fallen more than 15 percent since summer. That drop puts upward pressure on prices—because imported goods and commodities priced in dollars cost mores in euro terms. If a new imported Cadillac now costs a Berlin driver 15 percent more in local currency, it's a lot easier for the local Mercedes dealer to pass along a price increase.

Still, the downward price pressure in Europe is coming from more than just oil. Since the Great Recession, the global cost of most commodities has been on a long-term downward trend.

From nickel to soybean oil, plywood to sugar, global commodity prices have been on a steady decline as the world's economy has lost momentum. That lower demand helps explain, in part, why nearly everything from crude oil to cotton has been getting cheaper.

The chart below is based on global prices, in dollars, assembled by the World Bank.

Sure, some commodity prices are rising. Local supply constraints have pushed prices higher in some parts of the world; transportation costs can also have a big impact on local prices. In the U.S., for example, a drought in California caused the price of vegetables and other food products to spike last year.

Prices are also rising for some commodities, especially meats such as beef and chicken, thanks to growing demand from an expanding middle class in the developing world.

But around the world, the prices of food, chemicals, metals, lumber and other raw materials have been falling. That can be good news for countries that consume more than they produce in Europe and elsewhere.

In Asia, for example, China's energy bill has been falling along with crude prices. Other big commodity consumers like India are also seeing lower import costs for fuel and raw materials, helping to ease downward pressure on the rupee. Indonesia, one of the world's biggest oil importers, is getting a break on lower crude prices.

But as a big exporter of coal, Indonesia has also seen those revenues fall by a quarter this year. Australia, which relies heavily on coal and iron ore exports, has seen revenues fall, raising the prospect of the country's first recession in 20 years.

Read More Crude price slide hits oil exporter currencies

If global growth picks up, stronger demand could help reverse the slide in commodity prices. But there are other forces at work that could continue to depress prices over the longer term.

One is the ongoing strength in the dollar, which is getting a lift from the relative strength of the U.S. economy. That's attracting investment to the U.S., reversing a move to countries whose developing are now weakening, especially those that rely heavily on commodity exports. Because commodities are priced in dollars, the strength of the U.S. currency accounts for some of the downward pressure.

But shifting investment also helps explain the longer-term decline in a wide range of commodities, following a boom in commodity investment that has been unwinding since the Great Recession.

Much of that investment flowed into derivatives, investments in paper backed by commodities, not the underlying goods themselves. That investment helped artificially force commodity prices higher than the underlying demand.

Now, with that speculative wave unwinding, the world may see cheaper commodities prices for some time, said Brian Reynolds, chief market strategist for Rosenblatt Securities.

"Wall Street structured the equivalent of $22 trillion worth of commodities through OTC commodity derivatives and now they're unwinding," he said. "This is a permanent decline, for probably five to 10 years."