federal reserve

Deflation? Really?

Tuesday, Oct. 6, 2009
Posted 10 a.m.

The subject of deflation comes up often, such as last week when PIMCO's Bill Gross stated he was adding to positions in U.S. Treasuries as a defense against deflation. Protecting against the potential of deflation is one thing, especially when a range of outcomes is possible. Gross and his investment committee have alternately voiced concerns over inflation and deflation in recent months.

But in isolation, deflation is not an especially probable outcome. It could happen, yes. Some have pointed to the current year-over-year readings on the Consumer Price Index as evidence that we're already experiencing deflation. Nonsense!

Excluding volatile food and energy prices, which I'll get to in a minute, core inflation is up 1.4 percent over the past 12 months. Not too hot and not too cold, but certainly not deflation.

The headline CPI that incorporates food and energy is being whipsawed by energy prices, as mentioned in my Sept. 18 post. One year ago, a gallon of regular gasoline was $3.64. Today it is $2.42, making a nice year-over-year comparison that puts the Consumer Price Index in negative territory, at -1.4 percent.

But make a note of this. On or about January 14, 2010 at 8:30 a.m. Eastern, the December CPI will be released and at that point it will be a different story. If the CPI were to hold steady for the remainder of the year -- in other words, we saw no price changes, up or down, through the remainder of the year -- the December reading of the CPI would jump to the positive side of the ledger at a 1.8 percent year-over-year increase. And again, that assumes no further price increases for the rest of the year. So it could well be higher than 1.8 percent by year-end. We won't be hearing talk about deflation at that point, I suspect.

By itself, 1.8 percent annual inflation is very desirable. If given the chance, we'd sign up for a lifetime of such low inflation as it would help keep interest rates low and minimize the erosion of buying power. But given the outlook for huge government debt service, continued dollar deterioration, higher commodity prices in the years to come, inflation seems very likely to be headed for higher levels. High unemployment and prevailing weakness in the economy may mask this for part of 2010, but as our overseas counterparts return to stronger economic output and higher interest rates, higher inflation here at home is a likely result.

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