Deflation Unlikely But Not Impossible

For now, when it comes to consumer prices, Goldilocks carries the day. Inflation is not too hot, not too cold. Even so, concerns about rising inflation, or deflation, won't fade away.

The Consumer Price Index in September saw a slight uptick, but over the past 12 months the CPI has fallen 1.3%. A year ago the deflation worry was larger for several reasons: GDP began to contract, the prices of oil and other commodities plummeted and prices of assets, especially housing, dropped sharply as well.

Last September, the threat of a global depression was real. To ward off a spiral of collapsing prices, the Federal Reserve embarked on a program that pumped about $2 trillion into shaky credit markets. That revived the market for commercial paper and also helped keep mortgage rates around 5%. Economic activity began to pick up.

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So why do some still worry? If the Federal Reserve withdraws most of that credit before consumer spending turns solid, the economy will sag and take prices of houses and stocks down with it. And that would occur at a time of substantial "slack," with the unemployment rate likely above 10% and idle factory capacity near a 40-year low. On top of that, there's an added worry that next year China, which is seeing rapid rises in stocks and property values, will crash, sending a deflationary tsunami toward the U.S.

A stronger argument can be made that the true threat is inflation. In theory the Fed should be able to throttle back the credit that it has pumped into the system during the course of 2010. But pressures of an election year could cause the Fed to go slower, allowing inflation pressures to build.

Our view: deflation is unlikely, but it will lurk in the shadows as long as unemployment hangs around 10%. Inflation won't pose a threat until the unemployment rate falls and approaches 7%.