Christine Lagarde: Beware of deflation

Christine Lagarde, head of the IMF, delivers warning about deflation in upbeat Davos meeting. Lagarde draws attention to dangers of Fed tapering and falling prices in the eurozone. 

Michel Euler/AP
Head of the International Monetary Fund Christine Lagarde speaks during a session at the World Economic Forum in Davos, Switzerland, Saturday, Jan. 25, 2014. She warned that the dangers of deflation still loom.

The International Monetary Fund's managing director warned Saturday of the risks posed to global economic recovery from the reduction of the U.S. Federal Reserve's monetary stimulus and falling prices in the eurozone.

Despite growing evidence the global economy is faring better than it has for years, Christine Lagarde said policymakers around the world have to be alert to the potential repercussions from the Fed's "tapering," a policy change it decided to embark upon in December.

So far, the move has been minimal — it has reduced the amount of bonds it buys each month by $10 billion to $75 billion — but many economists think that it could end this year if the U.S. economic recovery gains steam.

Over the past few years, the Fed's stimulus, in its various guises has had a big impact on financial markets. As well as shoring up stock markets around the world, the new money created by the stimulus has flown to emerging economies as investors sought out better returns. Currencies, such as the Indian rupee and the Brazilian real, have been beneficiaries. The withdrawal could prompt a reverse in those flows and see their currencies come under pressure.

"This is a new risk on the horizon and really needs to be watched," Lagarde said in a discussion about the global economic outlook at the World Economic Forum.

Though the shockwaves that have hit Argentina this week weren't specifically about tapering, the turmoil the country's currency experienced — it fell by nearly 15 percent on Thursday alone — was felt throughout the world, prompting stock markets to post broad-based declines.

Lagarde also cautioned about the outlook for the 18-country eurozone. Though the eurozone has emerged from its longest-ever recession and many of the bailed-out countries appear headed for modest growth, inflation has fallen sharply. At last count, it was down at 0.8 percent in the year to December, way below the European Central Bank's target to keep price rises just below 2 percent.

Many economists have worried that the eurozone may be about to suffer a debilitating bout of deflation, which Japan has experienced for the best part of two decades. Falling prices can hurt an economy as consumers postpone spending in the hope of getting cheaper deals in the future while businesses fail to innovate and invest.

Lagarde said the IMF thinks there's 15 to 20 percent chance that the eurozone may suffer deflation.

"The risk is that longer term expectations are anchored at a much lower level that it is currently associated with,"Lagarde said.

Getting out of a deflationary spiral can be hugely difficult. Japan is now undertaking a major policy experiment — dubbed "Abenomics" after Prime Minister Shinzo Abe — involving a massive monetary stimulus, more government spending and big structural reforms. The hope is to get inflation up at 2 percent.

The country's finance minister, Haruhiko Kuroda, said the early signs were positive and he voiced some optimism over the country's growth.

"We are only half way," he said. "There's still a long way to go."

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