Oct. 29 (Bloomberg) -- Deflation remains a threat to the euro-area economy and a greater risk in some countries, presenting a “headache” for the European Central Bank over when to tighten policy, according to Capital Economics Ltd.

While ECB President Jean-Claude Trichet said Oct. 1 that there has been “no materialization of deflationary risks” in the 16-nation economy, Capital’s European economist Ben May said in a report late yesterday that spare capacity leaves the region in jeopardy of a “prolonged and damaging period of falling prices.”

Spain and Ireland, both suffering from property-market crashes, are most vulnerable as they face falling demand and rising indebtedness, while Germany and France appear to be in the least danger, London-based May said. The varying risks may complicate the ECB’s ability to reverse record low interest rates and lending to banks, while it even raises the potential for countries to leave the single currency, he said.

“There is a significant chance that the region may suffer from large and prolonged divergences in economic performance,” May said. “Not only would this provide the ECB with an additional headache over the timing of the withdrawal of its stimulus measures, but it could even prompt the worst affected currencies to consider abandoning the single currency.”

Prices Fall

European consumer prices posted a fourth annual decline in September even after the Frankfurt-based ECB cut its benchmark interest rate to a record low of 1 percent in May, leant unlimited amounts of money to banks to spur lending and began buying covered bonds.

Of the euro-area economies, inflation is likely to slow the most in economies such as Spain and Ireland where consumer spending has plunged and indebtedness is high, Capital said.

The Spanish and Irish governments will also run bigger budget deficits in the next two years, suggesting they may eventually have to tighten fiscal policy “earlier and more sharply” than their neighbors afterward, May said.

By contrast, the resilience of household demand and stronger balance sheets will leave retailers in Germany and France under less pressure to cut prices to maintain sales, the report said. Southern European economies have also become less competitive since the euro’s introduction 10 years ago, making those to the north more likely to benefit from export growth, it said.

Impact Fluctuates

While productivity gains would help spur wages and profits, supporting spending and reducing the deflation threat, the impact varies across the region. May says Spain and Italy are the least efficient, with Greece, Finland and Ireland better placed. Even the positive impact of falling prices fluctuates from country to country, with any boost to external competitiveness likely to benefit the euro region’s most open economies -- Ireland, Spain and Netherlands.

The likelihood of deflation occurring will depend on the spare capacity created in the slump, the length of time it takes for this to reverse and how prices react, according to Capital.

May calculates that were the so-called output gap, a measure of excess of supply versus demand, to widen to around 4 percent of gross domestic product, that may push core inflation down 2 percentage points for every year it remains there. Core inflation, which excludes energy and food, was 1.2 percent in September.

European Commission figures published today showed that factories increased capacity usage on assembly lines for the first time in two years this quarter, with capacity utilization rising to 70.7 percent from 69.6 percent in the third quarter.

“The full effects of the huge increase in spare capacity caused by the recession have not yet fully fed through to inflation,” said May. “The recent run of upbeat economic data from the euro-zone has led some commentators to conclude that the risks of deflation have diminished. We are not convinced.”

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net

Last Updated: October 29, 2009 08:05 EDT