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Don't Dismiss Deflation

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.
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A jump in the core U.S. inflation rate has persuaded many people that deflation is no longer a threat. But even those who never subscribed to the idea that consumer prices might decline for a sustained period should be wary of misreading the data and dismissing the risk of deflation.

QuickTake The Trouble With Falling Prices

Core U.S. consumer prices, excluding food and energy, rose 0.3 percent in January from December. Figures published on Friday showed annual prices paid by for goods and services by consumers, excluding food and fuel, jumped 1.7 percent last month, already outpacing the 1.6 percent pace the Fed had forecast for the final three months of this year. And the annual core CPI rate is now at 2.2 percent, the fastest pace since June 2012:

Sure, consumer expectations of inflation three years hence have dropped to 2.5 percent from as high as 3.8 percent in August 2013, according to the New York Federal Reserve’s monthly survey. But last month, the actual headline inflation rate was much lower, at a seasonally adjusted 1.3 percent. When prices rise, people think the devil or other forces outside their control are at work. But when they pay less, it’s because they’re smart shoppers.

Consumers (and even economists) also aren’t aware that there's deflation in goods prices. In December, the goods component of the inflation index fell 2.2 percent. With the ongoing collapse in commodity prices, even more deflation will feed through to consumer goods in the coming months. Copper prices are down 20 percent in the past year, iron ore almost 25 percent, soybeans 13 percent and sugar 12 percent, while the overall Bloomberg Commodity Index has plummeted 26 percent. Since my Feb. 16, 2015 Bloomberg View column "Get Ready For $10 Oil," West Texas Intermediate crude oil has dropped to about $32 a barrel from $63, and looks destined to reach my $10 to $20 target.

Furthermore, U.S. consumers aren’t spending the windfall from lower gasoline prices and thereby spurring the economy and prices. Since November 2014, when OPEC refused to cut oil output and energy prices fell off the cliff, motorists have benefited by $86 billion from lower gasoline prices. But they increased their savings by an additional $82 billion over and above the pace they were reducing debts and building assets at before gasoline prices dropped:

There’s also a link between the prices of goods and the costs of services, so the annual inflation rate for services has declined to 1.9 percent in December from as high as 2.5 percent in May 2014. (Laid-off oil field workers don’t take as many vacations; they frequent bars and restaurants less often.)

In addition, inflation worriers tend not to look beneath the headlines to acknowledge that the CPI measure considerably overstates inflation. Many quality improvements aren’t reflected in prices, despite what are called hedonic quality adjustments designed to capture improved performance. A new laptop, for example, may cost the same as its predecessor but have 10 times the computing power. Also, the CPI has fixed weights and doesn’t reflect the fact that when oranges are cheaper than apples, people buy more oranges.

This overstatement is especially true in the housing area. Believe it or not, the CPI assumes that homeowners rent their abodes from themselves at current market rates. That so-called owners’ equivalent rent contributes 24 percent of the headline consumer price index, and 31 percent to the core inflation measure. This distorted measure is principally based on the relatively few single-family houses that are available in the rental sector.

With high student debts, job insecurity and low credit scores, many potential homeowners have been renting instead. So rental costs have been leaping and owners’ equivalent rent jumped by an annual 3.2 percent in January, the fastest since the middle of 2007. But do homeowners really know or care what the rental value of their home might be? Does it affect their spending and saving behavior? That seems unlikely.

Without this fictitious number, the annual core inflation rate for January almost halves to 1.2 percent from the reported 2.2 percent figure, while the headline number drops to 0.6 percent from 1.3 percent. Since September 2011, when rents started to accelerate, the compound core annual growth rate was 1.8 percent but 1.1 percent excluding owners’ equivalent rent while the numbers for headline CPI are 1.1 percent and 0.4 percent, respectively.

Furthermore, my research suggests that while the earlier zeal for renting versus buying widened the gap between rents and home ownership costs, the difference is starting to narrow. Homeownership has become relatively cheap; a combination of overbuilding of apartments plus foreclosed single-family houses being converted to rentals mean the market is getting flooded. So the owners’ equivalent rent component of the CPI will rise much more slowly, if not fall, in the future.

So, in my judgment, deflation remains not just possible but probable -- even more so once the contrived fiction of owners’ equivalent rent is eliminated from the calculations. And this matters because the value of the consumer price index reverberates through the economy, ranging from cost-of-living assessments to the returns on U.S. government inflation-linked debt to how the Federal Reserve shapes monetary policy -- something I will explore in my next column on Tuesday.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
A Gary Shilling at insight@agaryshilling.com

To contact the editor responsible for this story:
Mark Gilbert at magilbert@bloomberg.net