At Least Inflation Is Under Control

Risks of deflation lurk, but odds of that problem occurring are low.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

November 19, 2008

The plunge in consumer prices in October will continue for a month or two, reflecting a sharp decline in energy prices the past couple of months. It will also escalate chatter about the risks of deflation. But inflation will not evaporate, even as the economy deteriorates and asset values keep falling the next few quarters.

The Consumer Price Index likely will rise about 1.5% in 2009 after gaining around 3% in 2008, mostly driven by soaring fuel and food prices earlier in the year. The CPI, the government’s chief benchmark for measuring inflation at the retail level, was last below 2% for the year when it rose 1.9% in 2003.

An outright decline, the first since a minus 0.7% in 1954, can't be ruled out. But crude oil prices, now trading around $55 a barrel, would have to drop to $40 a barrel and stay there for that to happen, says Diane Swonk, chief economist with Mesirow Financial in Chicago. We’re not yet convinced that oil prices are going to collapse.

October's 1% monthly CPI drop is the biggest in 61 years, since the Department of Labor started tracking the seasonally adjusted measure in February 1947. The recent decline marks a sharp reversal from earlier this year, when oil and gasoline prices were surging. For example, in July, when oil peaked at $147 a barrel and some drivers were paying $4 a gallon at the pump for gasoline, the CPI increased 0.8%. Over the past 12 months, the CPI has risen 3.7%.

Now relief is also appearing through moderating increases in food prices. A report earlier in November on the Producer Price Index signaled easing over the next several months at the wholesale level. While this is good news for consumers, it will further squeeze profits for producers and commodity firms.

But the abrupt turnabout in prices is welcome news for households and for central bankers. The Federal Reserve doesn't have much room to cut the short-term rates that it controls: They are already at 1%. But the absence of higher inflation removes the prospect of having to raise rates to rein in inflation over the next year or so.

Price declines were numerous and included apparel, new and used cars and airfares. But some prices continue to increase, including rent, medical costs and education.

The Fed keeps an eye on the core rate of inflation, which excludes volatile energy and food prices. That rate fell 0.1% in October. For the past 12 months the core rate has gained 2.2%, a rate that policymakers can certainly live with, considering all the other problems they have to combat.

The risk of deflation is one of those problems, but it's unlikely to happen. What’s more likely is that inflation will stay positive, albeit low. Still, while most households were expecting moderation, not a drop, the latest monthly snapshot of consumer sentiment by the University of Michigan shows that nearly 40% expect inflation to be zero or negative in 2009.

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