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Economic Forecasts

April's Price Drop Doesn't Equal Deflation

We see modest inflation this year — and next — as the economy recovers.

Sliding consumer prices in April will likely elevate worries about deflation -- a persistent decline in prices and incomes with potentially severe economic implications. At present, the burden of carrying extremely high debt levels is mitigated for both households and the federal government by historically low interest rates. But if incomes began to slide, as they would if deflation takes hold, borrowers’ ability to stay current on these debts would be impaired. Loan losses would increase, and wealth would fall.

We view the scenario as highly unlikely. As the economic recovery progresses, the huge overhang of excess capacity -- including unemployed workers and idle factories -- that’s pushing inflation lower will steadily diminish. And as it does, wages and prices will begin to firm. Near term, we expect core inflation, which excludes the notoriously volatile food and energy items and better reflects underlying trends, to remain historically low, at just 1% this year. But in 2011, it’s likely to inch up to 1.5% or so.

The core Consumer Price Index was unchanged for the second month in a row in April. Measured against a year ago, the core CPI increased a mere 0.9% -- a 47-year low. The overall CPI fell 0.1% in April, mostly because of declining energy prices. Commodity prices in general are under pressure for two reasons: Worries about the European economy are dampening expectations of global growth, implying diminished demand for raw materials. And the strengthening dollar -- rising in value as the European financial crisis lingers -- tends to raise the cost of commodities to purchasers using other currencies. The dollar is generally the currency of choice for pricing commodities.

But commodity prices will rebound from the near-term slump. Although Europe’s problems are not to be trivialized, the worst-case scenario of serial government defaults seems unlikely. And as it gradually pulls out of the morass, improving growth and diminished risk aversion ought to lift the euro vis-à-vis the dollar and buoy commodity prices. Look for overall inflation around 1.7% this year and next.

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