Should We Worry About Disinflation?

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Today's report on June consumer prices, with its gasoline-driven increase of 0.5 percent, may allay the immediate concerns about falling inflation, but it's unlikely to alter the underlying theme: Four years after the end of the recession, U.S. inflation is still slowing, the Federal Reserve's money-printing operations notwithstanding.

Some policy makers say the Fed is being too cavalier about disinflation. The central bank's preferred inflation measure, the personal consumption expenditures price index, rose 1 percent in May from a year earlier. St. Louis Fed President James Bullarddissented at the June 18-19 meeting because he wanted the committee "to signal more strongly its willingness to defend its goal of 2 percent inflation." And Boston Fed President Eric Rosengren has warned of the risk of getting stuck in a deflationary cycle.

There is nothing magical about an inflation target of 2 percent compared with, say, 1 percent. I bet the average consumer can't discern the difference between a 1 percent increase in the cost of living and a 1 percent decrease. Most consumers seem to think that the price of fill-in-the-blank-with-whatever-they-buy is rising by leaps and bounds.

Over the past decade, the PCE price index has increased 2 percent a year on average. The 20-year average is 2.6 percent. For the consumer price index, the corresponding increases are 2.5 percent and 2.9 percent. Outside of an asset bubble here or there, the Fed has pretty much achieved price stability.

The only reason the Fed and other central banks prefer a positive inflation target is to give them room to lower real, or inflation-adjusted, interest rates when the economy goes into a dive. The single biggest component of the CPI -- almost a quarter of the entire index and 32 percent of the core -- isn't even a directly observable price. "Owner's equivalent rent" measures the imputed rental value of a primary residence. It's what owners would have to pay if they rented their own home.

Until 1983, the CPI measure of homeowner costs was based largely on house prices. Because a house is an investment, and the CPI and PCE price index attempt to measure the prices of consumer goods and services, the Labor Department shifted to the rental-equivalence approach. One can only imagine the early warning signs -- and policy response on the way up and the way down -- if home prices were still included in the CPI.

So is it time to sound the alarm bells? I think not. Although the economic data have been uninspiring of late, there are reasons to wait to see how things play out. Consumer confidence is near a post-recession high. Job growth has exceeded output growth. Tax receipts for the first nine months of fiscal 2013 are running 14.4 percent ahead of last year. Asset prices -- think stocks and houses -- are doing quite nicely.

And one more thing. The last I heard, the Fed was debating when to taper the size of its asset purchases, not increase them.

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