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Another month and we get another dismal inflation number out of Europe. Yet despite the clearest of indications that European inflation is now headed well into the danger zone, Mario Draghi and his cohorts at the ECB remain in denial about the risk of Japanese-style deflation in Europe. Sadly, this denial makes it all too likely that the ECB will remain well behind the policy curve, which will only heighten the risk that Europe in the end will experience deflation.

The troubling aspect of the latest inflation numbers is not so much that they suggest that European headline inflation has decelerated from 2.2% in the year-ended December 2012 to 0.8% in the year-ended December 2013. Rather, it is that core price inflation, which excludes food and energy prices, has more than halved from 1.5% for the year ended December 2012 to 0.7% for the year ended December 2013. This takes European inflation dangerously below the ECB's inflation target of "close to but below 2%."

The key policy mistake that the ECB now appears to be making is not to associate the sharp deceleration in European inflation to the record high European unemployment rate or to the very large gaps that now characterize the European product markets. This mistake is all too apparent in the ECB's latest economic forecast. While the ECB does project that over the next two years the European recovery will not be strong enough to reduce unemployment much below its present record level of around 12% by the end of 2015, it does project that European inflation will somehow pick up.

Another policy mistake that the ECB now appears to be making is that it is not giving due weight to the fact that there is a wide divergence of inflation rates among the 18 member countries that now comprise the European Monetary Union. Specifically, it is not giving due account to the fact that while inflation in countries like Germany is close to the ECB's inflation target, a number of countries in the European periphery are now already experiencing outright deflation. This could have important consequences since deflation in the periphery could make it all but impossible for those countries to dig themselves out from under their massive public and private sector debt burdens. And failing to reduce their debt levels risks raising new questions about those countries' debt sustainability.

In the months ahead, like Japan before it, the ECB will learn the painful lesson that large gaps in the European labor and product markets can drive large parts of Europe into deflation. Sadly, this could prove to be a very expensive lesson not only for Europe but also for the rest of the global economy.

Source: Europe In Deflation Denial