The Newest Fear

Producer prices are up sharply since last year, but the Fed isn't worried about inflation

By Joseph Lisanti

It's a word that few investors today have ever used, except in describing the 1930s. Yet, people are now openly discussing the possibility of deflation in the U.S. economy. Is the threat real?

The Federal Open Market Committee's statement following its May 6 meeting never mentioned the word deflation. But the message was clear: The Fed now fears it more than inflation. We've lived quite comfortably with some forms of deflation. A personal computer cost several thousand dollars 20 years ago. More powerful machines sell for only a few hundred dollars today.

Even prices of some more ordinary goods have declined. Since 1993, the average price of apparel for U.S. urban consumers has fallen more than 7.5% (not seasonally adjusted), while the overall consumer price index rose about 27%.

Near term, some degree of inflation looks more likely, says S&P chief economist David Wyss. Employment costs jumped 1.3% in the first quarter, boosted by the 2.2% rise in the cost of fringe benefits, including health care. Despite some easing in April, producer prices have climbed much more rapidly than consumer prices since the middle of last year.

The recent rise of the euro against the dollar is also inflationary. It not only makes imports more expensive for U.S. consumers, it also gives domestic producers cover to raise prices in an attempt to recoup mounting costs.

But the rising euro is deflationary for Europe. Imports from the U.S. cost less in euros and local producers can't easily raise prices because of the competition. Meanwhile, Japan has been fighting deflation with little success for more than a decade.

Therein, says Wyss, lies the source of the Fed's fear: Deflation in both Japan and Europe could pull the U.S. in. Although the risk is low, Wyss expects the Fed to cut rates in June just for insurance.

And another cut should boost stocks.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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