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Time for Deflation Jitters?

By Rick MacDonald While the sharp slowdown in economic growth since the September 11 attacks has grabbed most of the economic headlines, the related impact on the pricing power of U.S. businesses has been just as dramatic. In fact, several key inflation measures posted some of their biggest declines in history in October, most notably the producer price index (PPI).

The Bureau of Labor Statistics' PPI report, released Nov. 9, showed wholesale prices declining a record 1.6% on the month -- a much greater drop than the 0.4% Wall Street economists were expecting. The Street figures that a similar picture will appear on Nov. 13, when the government reports what consumer prices did in October.

A drop in prices, of course, suggests a scary term from Econ 101: deflation, when prices contract -- which is inflation's more-evil twin. A prolonged bout of deflation can spell disaster for the economy because, even if demand picks up, companies are unable to generate profits if they have little or no control over what they can charge.

However, while commodities have seen a breathtaking price drop since the September attacks, the outlook for broader price measures is more subdued -- meaning the likelihood of a sustained period of deflation for the U.S. economy isn't likely.

KEY QUESTIONS. This is largely because the broader price gauges such as the consumer price index or Federal Reserve Chairman Alan Greenspan's reported favorite, the personal consumer expenditures price index (part of the quarterly gross domestic product report), include a large representation of the service economy in their makeup. And prices in the service sector tend to be much more stable than in the goods sector.

That's because labor costs are generally steadier than material costs. Still, service providers are exposed to employment costs to a great degree, and Standard & Poor's MMS expects the sharp slowdown in economic growth and deteriorating conditions in the labor market to have a dampening impact on inflation among services going forward.

In fact, the October employment report may have provided the first glimpse of disinflationary pressure (a slowdown in the inflation rate, not to be confused with the outright falling numbers of deflation) on the labor front, as hourly earnings for the month rose a smaller-than-expected 0.1% -- dropping to 3.8% from a September peak of 4.5%.

WILL THE CUTS KICK IN? The current price weakness raises a few key questions: Does the speed of recent deflation reflect an ability by companies to adjust pricing in real time to sudden shifts in demand? Or, on a much more ominous note, does it reflect global overcapacity? In addition, do the sharp price declines for raw materials used in manufacturing suggest more downward pressure on corporate pricing power? Or will companies be able to take advantage of cheaper inputs to bolster margins for finished goods?

Meanwhile, inflation's lower trajectory implies a higher "real" (that is, adjusted for inflation) federal funds rate. And that leaves more room for the Fed to cut rates, which could be crucial considering that the key short-term rate the Fed controls has been cut to 2% from 6.5% so far this year. The downside: The 10 interest rate cuts so far this year by Greenspan & Co. haven't yet packed the punch expected or needed.

The PPI isn't the only recent report with a deflationary cast. Prices of goods took a huge deflationary hit in October, as several of the key commodity price indexes dropped to multiyear, if not multidecade, lows. The Commodity Research Bureau Futures Index, a widely followed gauge of raw-material-futures prices, dropped to its lowest level since June, 1975. The Goldman Sachs Commodity Index, which is dominated by energy swings, reached its low point since August, 1999, and plummeted 9.3% on the month -- the worst decline since December, 1990.

HISTORIC LOWS. Other inflation measures are consistent with evidence that deflationary pressure is gripping the goods market. The prices-paid component of the October National Association of Purchasing Management's manufacturing survey crashed to a reading of 32.5, from 36.3 in September -- the lowest measure since July, 1949.

The Agricultural Index of prices received by farmers dropped 10% in October, marking the worst fall in 26 years. And the Economic Cycle Research Institute's U.S. Future Inflation Gauge also plunged to a 26-year low in October, with the report indicating that it underscores "the rapid drop in inflationary pressures triggered by the first synchronous global recession since 1973-1975."

The bottom line: This recent spell of falling prices suggests that coming inflation reports will be tamer than the market expects. It also has important potential implications for economic growth, corporate earnings, and central bank policy. MacDonald is senior economist at Standard & Poor's Global Markets

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