Inflation at 53-Year Low Belies U.S. Demand Vigor

Some Federal Reserve policy makers are citing the lowest inflation rate in at least five decades as an alarm bell for the economy. Economists at UBS Securities LLC say the figure isn’t as troubling as it appears.

Consumer prices climbed 1.1 percent in the 12 months through April, according to a measure watched by the Fed that excludes food and fuel -- matching the smallest increase since records began in 1960. That’s down from 1.9 percent in the year ended April 2012.

Most of the decline is in industries such as apparel and health care, where consumer demand is growing, said Sam Coffin, an economist at UBS Securities. Among the reasons for slowing inflation are improved efficiency and a stronger dollar, which puts downward pressure on prices of imported goods such as cars and clothing.

“If anything, the price softening is helping to support demand,” and the dollar is set to rise further, said Coffin, who is based in Stamford, Connecticut. “Households are getting a little bit more purchasing power out of their income growth.”

Fed officials meeting June 18-19 in Washington will weigh how much changes in inflation and the labor market will influence the pace of their $85 billion in monthly asset purchases. James Bullard, president of the St. Louis Fed, this week said inflation below the central bank’s 2 percent target may warrant prolonging bond buying.

“Slowing inflation has twice spurred Fed fears that deflationary psychology could damage the recovery as consumers postponed purchases,” Coffin wrote in a June 3 research note.

QE1, QE2

Policy makers expanded their first round of quantitative easing in March 2009 by announcing they would buy Treasuries in addition to mortgage-backed securities and debt of government-sponsored enterprises as the inflation measure cooled to 1.4 percent on its way to reaching 1.2 percent that July.

In November 2010, the Federal Open Market Committee announced a second round of Treasury security purchases, or QE2, totaling $600 billion as price increases again slowed.

Yields on Treasury securities and mortgage rates have surged as gains in employment prompt speculation the Fed will soon reduce asset purchases. At the same time, declining inflation gives the Fed room to maintain record economic stimulus as policy makers led by Chairman Ben S. Bernanke seek to lower a jobless rate of 7.6 percent.

Elsewhere today, data showed the economy in the U.K. is gathering momentum as jobless claims fell in May and the unemployment rate dropped in the three months through April.

Bullard’s Concern

Bullard has expressed concern since 2010 that disinflation is indicating a lack of demand that will trigger a cycle of falling prices and spending declines like the one that has afflicted Japan for 15 years.

The situation in the U.S. is less dire, according to Coffin, whose research shows that four industries -- financial services, clothing, medical care and automobiles -- accounted for about 75 percent of the deceleration in core inflation.

His calculations show goods and services from the health-care industry account for 0.18 percentage point of the slowdown in prices in the year ended April.

Changes in response to the 2010 health-care overhaul may be helping lower costs as hospitals improve efficiency and reduce readmissions, while expanded use of cheaper generic drugs may also be holding down prices, Coffin said.

Financial services and insurance accounted for another 0.17 percentage point of the deceleration in core prices. Some of these costs can’t be measured directly, for example free checking accounts, so the government estimates their value.


Both health care and financial services represent non-discretionary expenditures, meaning consumers don’t have the ability to delay purchases. “Price disinflation or even deflation for these services is unlikely to dampen real consumer spending,” said Coffin.

Autos accounted for another 0.08 percentage point of the slowdown and clothing made up the remaining 0.2 percentage point. Here, a rising dollar may be playing a role, according to UBS research.

With automakers posting their best sales in more than five years, deceleration in the motor vehicles and parts category of the personal consumption expenditure, or PCE, price index is reflective of dollar strength that’s held down import prices, as well as domestic producers competing for market share as orders pick up, the UBS report showed.

Cars and light trucks sold at a 15.2 million annualized rate in May, making it the sixth month out of the last seven to exceed the 15-million mark -- a level that previously hadn’t been breached since February 2008.

Rising Dollar

Apparel prices have been held back by dollar appreciation and “exaggerated” monthly swings that don’t match other retail sales figures, he said.

The Dollar Index, which IntercontinentalExchange Inc. uses to track the greenback against currencies of six U.S. trading partners, increased 1.7 percent from the start of the year through June 11 to 81.11. The gauge rose to 84.35 at its May 22 close, the highest level since July 2010.

New York Fed President William C. Dudley is among officials looking beyond the slowdown in prices. He said in April that while “underlying measures of inflation are subdued,” expectations for future price increases remained “well anchored,” which eases concern the slowing will continue.

Jeffrey Lacker, president of the Richmond Fed, told reporters in Baltimore the day before that a slowing in inflation is temporary and prices will probably rise at about a 2 percent annual rate.

Inflation Expectations

The gap in yields between Treasury Inflation-Protected Securities, or TIPS, and U.S. government debt not indexed for inflation, known as the break-even rate, shows investor expectations for the consumer price index over the next 10 years were at 2.09 percentage points on June 11. They have held above the Fed’s 2 percent goal since the start of 2012.

The steady expectations give the Fed room to maneuver even as actual inflation ebbs, said Harm Bandholz, chief U.S. economist at UniCredit Group in New York.

“If inflation expectations would have reacted to these very low core PCE numbers, we would see more people talking about increasing” the Fed’s quantitative easing, Bandholz said. With expectations remaining relatively stable, Fed officials are “discounting a little bit the very low core PCE reading.”

Slowdown Transitory

The Fed officials have said “this slowdown in inflation is probably transitory, which would imply that it really wouldn’t factor into their decision,” even as Bullard may have an alternate view, said Richard Moody, chief economist at Regions Financial Corp. in Birmingham, Alabama, who expects the Fed to begin tapering at their September meeting.

Inflation data set for release within the next week could intensify the debate on pricing trends. Import prices were little changed in May, economists project ahead of data tomorrow from the Labor Department, while a report released the following day may show wholesale prices rose 0.1 percent last month after two straight declines.

Data for the consumer price index -- due next week -- is projected to show a pickup, although the core year-over-year gauge probably held at a two-year low of 1.7 percent, according to early estimates.

UBS economists led by Maury Harris continue to forecast Fed policy makers will not begin to reduce bond purchases until early 2014 as concerns over the slowdown in price gains and the weakening in growth caused by the federal across-the-board spending cuts under sequestration hold sway.

Nonetheless, they said that investors will anticipate an earlier scaling back of the Fed’s program. To that end, last week UBS raised its forecast of the year-end yield for the benchmark 10-year note to 2.20 percent from a prior estimate of 2 percent. The note’s yield was 2.19 percent late yesterday.