U.S. Deflation Risk: Fact or Fancy?

November 17, 2010

The Fed is engaging in a second round of quantitative easing to ensure that the United States doesn’t slip into deflation.  Deflation can be like a stroke in that full functionality sometimes never returns.  Excessive inflation, in contrast, can always be conquered if monetary authorities have enough political backbone, which is why they tend to fear deflation more than inflation. 

It’s not surprising that the United States should be experiencing low inflation now since the jobless rate has been 9.4% or higher since January 2009 and capacity usage still lies below 75%.  But price levels are higher than a year ago.  U.S. consumer prices rose 1.2% over the twelve months to October, 1.4 percentage points more than in the year to October 2008.  Inflation of 1.2% is half as much as the 2.6% per annum pace in the ten years prior to the financial crisis but only slightly under its preferred range.

Angst is caused by the behavior of core inflation, which advanced just 0.2% at an annualized rate between July and October.  On-year U.S. core CPI inflation of 0.6% constitutes a record low in this data series, which began being reported in 1957.  The previous lowest 12-month increase in core CPI had been 0.7% registered in February and March of 1961.  The recent deceleration in consumer price inflation when energy and food are excluded has been unusually sharp.  0.6% is only a third as much as the 1.8% increase between December 2008 and December 2009.  From 1.8% last December, core inflation had been halved by April, remained at 0.9% until August, and was cut by another third in the ensuing two months.  When the United States had an inflation problem, core inflation rose from 3.1% per annum in the ten years to October 1970 to 7.2% per annum in the ten years to October 1980 and was still unacceptably high at 5.2% per annum in the next ten years to October 1990.  Deceleration continued to a pace of 2.9% over the ten years to October 2000, 2.0% during the five years to October 2005, and 1.9% per annum between October 2005 and October 2010.  Spliced into that long-term picture, the 0.6% current rate of core inflation appears to be a natural progression that may be now on a rendezvous with sub-zero levels barring policy intervention.

Critics of the Federal Reserve, who argue that the deflation risk is nowhere near what monetary officials believe, can point to the 4.3% rate of producer price inflation, reported earlier this week.  Producer prices are more sensitive to commodity price trends and thus less isolated from trends in global aggregate demand than are consumer prices.  Euroland’s latest on-year rate of PPI inflation of 4.2% is almost identical to America’s.  British PPI inflation is at 4.0%, while deflation-laden Japan has seen domestic corporate goods prices advance just 0.9% in the past year.

The deceleration of U.S. core inflation does appear to be unique and seemingly justifies a Fed policy that’s becoming more accommodative at a time when other central banks are either holding a steady stance or tightening.  The abrupt deceleration of core CPI inflation in the United States from 1.8% last December to 0.6% ten months later was not matched in the euro area, Britain or Japan. Core inflation in Euroland edged up a tenth to 1.1% from 1.0% at the end of last year.  British core CPI posted on-year increases of 2.7% in the latest reported month compared to 2.8% in December 2009.  Japanese core deflation of negative 0.6% in the year to October was only half as severe as the 1.2% drop between December 2008 and December 2009.  Chinese total CPI inflation tripled to 4.4% in October from 1.5% in January and was negative prior to November 2009.

The Fed has acted not because officials believe that deflation is the most likely outcome if they do not undertake more quantitative easing but rather as an insurance policy because deflation is no longer a remote possibility and would complicate policymaking immensely if it were to take root.  Japan did not plunge into negative inflation with a bang but rather very gradually.  Core Japanese consumer price inflation averaged 0.9% over the four years to 1998 at a time when the Bank of Japan’s overnight target rate was at 0.5%, and it has averaged minus 0.4% per annum since those years of deflationary prologue.  Total Japanese CPI inflation decelerated from 4.5% in January 1991 to 1.8% in the year to January 1992, 1.3% in January 1993, and 0.6% in January 1995.  The low-point prior to the world crisis was minus 1.6% in February 2002, and later a deeper low was reached of negative 2.5% in the year between October 2008 and October 2009.

The Fed is not attempting to prevent the kind of massive deflation that occurred in the 1930s but rather a milder but still nastily stubborn strain of the disease that Japan has been experiencing. Deflation in Japan has been associated with real economic growth of 0.8% per annum over the fifteen years between 3Q95 and 3Q10, down from 3.6% per annum over the previous fifteen years between 3Q80 and 3Q95.  That kind of development in the United States would keep the jobless rate above 9.0% for many years beyond the most pessimistic forecasts now floating among analysts.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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2 Responses to “U.S. Deflation Risk: Fact or Fancy?”

  1. Jenn says:

    This is a foolish debate. CPI was re-designed by the Boskin Commission in the 90’s to always produce a low number. Of course it will show lower numbers, it was designed that way. That does not prove deflation.

    It is not valid to compare the new post-1995 CPI with the older series

    Try looking at the actual cost of living for honest people (not government). Look at the Big Mac index. Real inflation is running 4-5%, just as the unrigged PPI suggests

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