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Why Deflation Fears Are Overinflated

By Michael Englund While the markets fret about the possible emergence of deflation -- a fear raised by no less than the Federal Reserve in its May 6 policy statement -- a close look at trends in second-quarter price data paints a different picture. The Fed's warning was perhaps less about deflation, and more a signal that price hikes won't accelerate. It's far from clear that the downside risks -- of either stepped-up disinflation or outright deflation -- have increased.

True, the U.S. chain-price index, which is used to adjust the nominal quarterly gross domestic product data for price swings to arrive at a figure that reflects "real" growth, is on track to post an impressive slowdown in the second quarter. That will leave Fed policymakers feeling quite comfortable with their newly heightened deflation warning.

We at MMS International expect only a 0.8% growth rate for the chain-price index in the second quarter, and a flat figure for the chain-price index for personal consumption expenditures (PCE) -- one of Fed Chairman Alan Greenspan's favorite tools for monitoring inflation.

THREE GOOD REASONS. Yet this weakness reflects the freefall already reported for the consumer and producer price indexes in April, and most market inflation projections do not yet reflect a full offset to the upside surprises in the inflation figures through March.

The inflation figures for the second quarter will highlight the absence of upside inflation risks to the economy. The flat personal consumption deflator expected for the quarter should include declines in prices of durable and nondurable goods at a 3% rate, following a 3.7% drop in durable prices and a 4.7% increase for nondurables in the first quarter. Import prices should fall at a 6% rate in the second quarter following an 11.6% increase in the first, while export price growth should slow to 1.4% in the second quarter from 3.6% in the prior period.

There are three reasons why second-quarter inflation data are at odds with the notion that deflation risks are rising. The first is that the projected second-quarter chain-price slowdown mostly reflects an unwinding of a huge and unexpected 7.8% surge in the deflator for government expenditures in the first quarter. This measure has a seasonal tendency to sporadically surge in the first quarter due to cost-of-living adjustments (for things like benefits programs) that the seasonal adjustments to data sometimes fail to fully capture. In such years, the deflators for government purchases fall below trend in the remaining quarters of the year, and we are assuming a 1.7% second-quarter government price drop.

DOLLAR DIVE. The second reason is that the "risks" to inflation overall have fallen now that we have put the war in Iraq behind us, and that lets us discount the extreme scenarios regarding oil prices that had been bandied about before the war -- ranging from price projections of $10 to $100 per barrel. As such, it's unclear where we might get the dramatic downside jolt to U.S. inflation that would be necessary to put the chain-price data into outright negative inflation territory.

Finally, the weakness in the dollar in the first half of 2003 has presumably raised the risks to inflation through the third and fourth quarters (see BW Online, 5/22/03, "A Down Dollar's Lure -- and Peril"). As a result, the ramifications of second-quarter price declines don't appear as great.

These reasons are brought into focus by comparing the current outlook for growth and inflation to the figures presented by the Fed in its monetary policy report to Congress in February. The central bank's economic projections, known as the central tendency forecasts, put the PCE chain-type price index in the 1.25% to 1.50% range for 2003. Given the data we've seen since then, it now looks like this deflator will overshoot the range with a 1.7% rise.

PRICE STRENGTH. An equal and opposite surprise is emerging with real growth, as we at MMS expect a 3.1% increase in GDP for 2003 that will fall short of the Fed's 3.25% to 3.5% central tendency forecast. We currently project nominal GDP growth of 5.1% in 2003, which may be just a rounding error away from the 4.75% to 5% central-tendency projection at the Fed.

In total, the Fed likely has higher 2003 inflation projections than those reported in February, and with less reason to expect an inflation shock in either direction now that the war in Iraq is over. Prices soared through March by a greater-than-expected amount, and are now posting a decline that's not yet fully offsetting. Meanwhile, the current dollar weakness actually implies new upside risk to prices.

And looking at a longer-term measure shows some surprising strength for prices in 2003. The chain-price inflation measure is on track to post a 1.7% gain for the whole year, given recent stability in energy prices, vs. the much smaller full-year 2002 gain of 1.1%, or the 1.3% gain registered in the 2002 fourth quarter over the year-earlier period.

So no matter how you measure it, deflation risks seem to have peaked in late 2002, and not now. The Fed's May 6 reference to deflation risk appears to be either an effort to highlight recent price weakness, or a perception that chances for an acceleration in inflation are diminishing more rapidly. Either way, it's clear that inflation won't be extinct in 2003, and that Greenspan & Co.'s assessment that outright deflation remains only a "minor" threat appears to be on the money. Englund is chief economist for MMS International

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