Deflation: Why the 'D' Word Is Back on the Table

Investors applauded the latest inflation news on Feb. 19. Despite a surge in the cost of gasoline and other energy products, consumer prices rose just 0.2% in January. Perhaps more important, core consumer prices—which exclude volatile food and energy costs and which are considered indicative of underlying inflation trends—actually fell 0.1% during the month. The news quelled financial market fears that the Federal Reserve would be forced to raise interest rates soon to keep inflation in check.

Investors would do well to curb their enthusiasm. Only months after its supposed demise, analysts are beginning to whisper the "D" word again. "Recent declarations of 'mission accomplished' in the fight against deflation risks now look somewhat premature," says Michael Feroli, an economist at JPMorgan Chase (JPM).

Deflation, even just the whiff of it, is something to be feared, not cheered. If widespread price declines take hold, they can be particularly debilitating for the economy. Faced with the prospect of depressed prices for products, companies are unlikely to expand operations or add workers. Falling prices also give already shell-shocked consumers yet another reason to hold on to their cash. Why buy something today that will cost less tomorrow?

What's more, deflation would be devilishly difficult for Fed Chairman Ben Bernanke and his colleagues to deal with. The lower prices fall, the higher inflation-adjusted interest rates rise, further reducing the willingness of companies and consumers to borrow and spend. The last time monthly core prices fell was in December 1982. The drop then was welcome news: It came at the end of a year when inflation clocked in at 6.2%, after a 10.3% reading in 1981. In sharp contrast, this January's decline occurred when inflation was already low. Overall consumer prices slipped 0.4% last year, largely the result of plunging energy costs.

The January drop left core consumer prices essentially unchanged from where they were in October. Over the last year, they've risen just 1.6%, well below the 10-year average of 2.2%.

Shelter costs—primarily the expense of renting or owning a home—have been a major factor in damping inflation. That's not surprising, given that they account for about one-third of the consumer price index (CPI). That has led some analysts, including James Bianco of Chicago-based Bianco Research, to argue that inflation has been distorted downward by the housing bust and its aftermath.

It's not only housing costs that are deflating. Prices on 44% of the products and services covered by the government's personal consumption expenditure price index—everything from personal computers to parking fees—fell in December, the latest data available at press time. That index gives less weight to shelter costs than the CPI, so it's seen by the Fed as a more accurate measure of inflation.

The real culprit behind the disinflationary trend: the huge amount of slack left in the economy after the Great Recession. U.S. industry operated at just 72.6% of capacity in January, up from a 40-year low of 68.3% last June but far below the 81% monthly average since 1967. With that much spare capacity still around, companies can't raise prices without running the risk of losing business to competitors.

That slack won't disappear soon, even with the economy in recovery. Janet Yellen, president of the San Francisco Fed, says it will take until 2013 for the economy to rev back up to its full potential.

Even so, some signs of inflationary pressures are emerging. Commodity and import prices are on the rise, spurred by a China-led boost in global demand. Raw material costs at U.S. companies jumped 9.6% in January, the most in three years. But wages, which with pensions and other benefits make up two-thirds of the cost of doing business, remain under wraps, held down by sky-high unemployment. Labor expenses rose at an annual rate of 1.5% in the fourth quarter. That's no recipe for robust recovery. The ingredients for a deflationary mix are still on the table.

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