The Jobless: Why There's No Inflation

Michael Feroli, chief U.S. economist for JPMorgan Chase (JPM), remembers the phone calls two years ago from clients "freaking out" about inflation. Federal Reserve Chairman Ben Bernanke had just launched his campaign to prevent the collapse of the financial system. He was pumping liquidity into the economy by making emergency loans to banks and buying mortgage-backed securities by the billions. He was also driving benchmark interest rates almost down to zero. Many investors feared Bernanke would trigger a price surge as consumers and companies borrowed more to spend, spend, spend.

Today, rates are still near zero, and liquidity is near a record high. Yet those client calls about inflation, says Feroli, have "dried up to a trickle." There's even talk of prices heading down.

Feroli and many other economists wonder just when inflation will make enough of a comeback to warrant a rate hike. That's turning out to be a hard call. Forty-seven economists in an Apr. 1-8 Bloomberg survey figured that, on average, rates would rise by Thanksgiving. Feroli and his boss Bruce C. Kasman, JPMorgan's chief economist, don't foresee a rate rise until the second quarter of 2011. Other economists predict a hike even later than that.

The big factor keeping a lid on inflation is the jobless rate, which has stayed above 9 percent since May 2009. This near-record stretch of joblessness has held down wages and consumption. The Fed's preferred inflation gauge—the core personal consumption expenditures price index, which strips out price hikes in food and energy—rose at an annual rate of 0.6 percent in the first quarter, the slowest pace since records began in 1959, according to the Commerce Dept.

Retailers feel every day how weak their pricing power is. Bentonville (Ark.)-based Wal-Mart Stores (WMT) cut prices on more than 10,000 items after sales at U.S. stores opened at least a year fell 1.6 percent in the fiscal quarter ended Jan. 31. Home Depot (HD), the largest U.S. home improvement retailer, lowered prices in March on flowers, fertilizers, lawn equipment, and outdoor furniture, according to Craig Menear, executive vice-president for merchandising.

Inflation this low can sometimes slip into deflation. A drop in prices effectively boosts the cost of a loan, since a company finds it harder to generate the profit it needs to service its debt. Deflation has gripped Japan for years and proved impossible to stamp out.

The money supply, which grows robustly when banks are lending and consumers are borrowing, also points to declining inflation. The broadest measure of the money supply expanded at an annual rate of just 1.4 percent in the 12 months through April, vs. 8.4 percent a year earlier. That's a clear sign that consumers have switched from borrowing to saving. Says Gabriel Stein, a director at Lombard Street Research in London: "One of the signals of threatening deflation is if money supply grows very slowly." We're not in a deflation zone yet, but economists in the Bloomberg survey predicted inflation of only 1.2 percent this year, vs. 1.54 percent for 2009. All the more evidence, says Feroli, that rate hikes will be a long time coming: "The inflation data continue to look weaker and weaker."

The bottom line: Inflation is low, and may stay low, because the high unemployment rate is forcing companies to keep a lid on prices.

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