Can the U.S. Stay Out of the Deflation Vortex?
Deflation is like a black hole, sucking seemingly everything into itself. Switzerland succumbed to the vortex on Jan. 15 when the central bank gave up trying to keep its currency from rising—a defeat that will punish the Swiss economy by making the nation's goods more expensive on world markets.
Could the U.S. be next? The U.S. dollar is up about 11 percent since last summer by the Bloomberg Dollar Spot Index, a rise that makes American-made goods less competitive. And there is a whiff of deflation in the air this morning with the news that the U.S. Consumer Price Index fell 0.4 percent in December from the previous month, the biggest decline since the economy was in free fall six years ago. "Deflationary pressures continue to build," Scott Anderson, chief economist at Bank of the West, wrote in a report today, Jan. 16, that cited a drop in import prices and came out before the news about the Consumer Price Index.
The bottom line is that the U.S. is probably safe. The economy is strong enough that it's likely to withstand the deflationary drag emanating from Europe. The U.S. should expand a little more than 3.1 percent in 2015, better than the estimated 2.4 percent this past year, according to the median forecast of economists surveyed by Bloomberg.
But that doesn't mean there's no risk. Deflation is dangerous because it can travel across international borders. Here's the concern in a nutshell: Europe's economy is chronically weak. With demand for goods and services weak, prices in the euro zone fell 0.2 percent over the past year. The European Central Bank is widely expected to try to revive growth by buying bonds to drive down interest rates. That makes the euro a less attractive currency for investors, sending them to other havens, whose currencies are rising. That's why the Swiss franc and the U.S. dollar are getting more expensive—and less competitive. In effect, if Europe's strategy is a success, it will improve European growth at the expense of growth in the U.S., Switzerland, and elsewhere.
The rise in the dollar vs. the euro is "great for Europe and their exports and not so much for American exports. ... The heat is on!" Mark Grant, managing director for taxable fixed income at Southwest Securities, wrote in a note to clients today.
Economists knew that falling gasoline prices would cause the overall price index to decline in December. What they didn't expect was the weakness in the "core" index, which excludes food and energy. The core index was flat compared with November's, while the median expectation was for a 0.1 percent increase. Prices of apparel, vehicles, and airfare fell in December.
Inflation that's well below the Fed's 2 percent target will make it harder for the inflation hawks on the Federal Reserve's rate-setting committee to justify raising interest rates this year. "Our expectation is that the policy debate is heating up as inflation cools off," the U.S. economics team of Bank of America Merrill Lynch wrote in a client note. On the other hand, the hawks can argue that the tightening of the U.S. labor market will push up wages this year and eventually put upward pressure on inflation. Paul Dales, senior U.S. economist at Capital Economics, wrote in a note today that lower prices for energy and imports "won't have much of an impact on services inflation, which makes up 75 percent of the core index." He notes that prices of shelter and medical care did rise in December.
"One positive from low inflation is that it is boosting workers' real (inflation-adjusted) earnings. With the big drop in gasoline and other energy prices, workers' paychecks are going farther, allowing them to boost their spending on other goods and services," Gus Faucher, senior economist at PNC Financial Services Group, wrote in a report today. Indeed, the University of Michigan preliminary consumer sentiment rose this month to its highest level in 11 years.