The spectre of deflation has been rising in Europe, the region that has been behind others in terms of its economic recovery.

European Central Bank (ECB) president Mario Draghi has suggested possible action to combat the threat of deflation over the last month or so, and at the central bank’s fortnightly meeting last week he finally duly obliged .

Earlier that week, it was reported that eurozone inflation had fallen further in May than the consensus forecast. The consumer price index, the ECB’s preferred measure, posted an annual rise of only 0.5 per cent to the end of May, compared to 0.7 per cent in April.

This rate of inflation is significantly below the ECB’s target level of 2 per cent, and provided further impetus for action to tackle the deflation that puts into jeopardy the recovery in Europe.

negative interest rates

The first measure that was announced to tackle the increasing threat of deflation was cutting the ECB’s deposit rate to -0.1 per cent. A negative interest rate should, in theory, discourage banks from placing high levels of funds on deposit with the central bank and encourage them to lend money out. The expectation is this will help improve credit conditions within Europe.

Negative interest rates on their own, however, may not be enough to encourage banks to increase credit in the economy. Indeed, if the banks made a conscious decision not to increasing lending, they would actually be penalised, a consequence which Draghi would wish to avoid.

This is particularly pertinent as banks in the eurozone try to increase their capital ratios ahead of Basel III legislation and ahead of the forthcoming Asset Quality Review, an audit of European banks’ balance sheets.

Recognising this, the ECB, to complement the move to a negative deposit rate, also announced that it is to create a €400 billion (£322.34 billion) liquidity channel tied to bank lending. Under this new facility, financial institutions will be able to borrow money from the ECB up to an amount equal to 7 per cent of their outstanding loans to non-financial corporations, excluding mortgages. Maturity of such loans can be up to four years.

It is hoped that this will encourage bank lending and improve credit growth in the region, which continues to contract, despite government bond yields being near record lows. To encourage banks to lend out these available funds, if, after two years, the banks have still not lent them out to customers, they must repay the cash to the ECB.

The above measures, combined with the potential for an asset purchase plan which will likely target asset-backed securities in particular, should hopefully increase lending within Europe. Credit expansion is necessary within any recovery to encourage economic growth.

A deflationary environment encourages the consumer to save, rather than spend, on the premise that they will be able to buy something cheaper at a later date. This is an economic condition which Japan has suffered from for over a decade, and its situation shows how hard it is for an economy to pull itself out of deflation once it is stuck in there.

What are the potential investment implications of these actions?

The immediate reaction to the announcements has been positive for the European government bond market, particularly in the periphery, with yields falling (prices rising).

Spanish 10-year government bonds currently yield 2.59 per cent, below the yield on UK 10-year gilts of 2.69 per cent. The yield on Italian 10-year government bonds is only marginally higher at 2.71 per cent (source: Bloomberg, 9 May 2014). This is good for the holders of those bonds, who benefit from them rising in price, but does not represent a good buying opportunity.

European banks, should they decide to utilise the facility and lend while placing less on deposit with the ECB, could also be beneficiaries. The rate charged for using this new liquidity facility is low, which should enable them to generate a healthy return on the loans they subsequently make.

This will of course be dependent on them setting their lending criteria correctly so as not to increase bad debt provisions (allowances set for defaults). This means that funds allocating heavily to European banks, like the Neptune European Opportunities fund. are likely to do well if banks play their cards right.

European equity markets in general should benefit over the longer term, as an improving economic backdrop should be a key driver of top line sales growth and ultimately corporate profitability. Some inflation is not to the detriment of equities, only high inflation, and we are clearly some way off that.

The eurozone economy has been lagging others this year, so now may be an attractive buying opportunity, particularly in light of equity market valuations relative to other developed markets, but as ever we will be watching carefully to examine how the recovery develops.

Paul Milburn is investment analyst at Lowes Financial Management.