Deflation Watch, Day 2: Consumer Prices

by: James Picerno

Yesterday it was producer prices; today it's consumer prices. The collective message is all the clearer: the risk of deflation is rising.

Consumer prices dropped 1% last month--a huge decline for a single month and the biggest on record, based on historical data on the Labor Department's web site going back to 1947.

Core inflation, which excludes food and energy, dipped by 0.1% in October, suggesting that the falling prices depicted in headline inflation is more than just a function of slumping commodity prices. And since the Fed focuses on core readings of inflation, last month's dip in core CPI reminds that the central bank is losing control of the pricing environment. Indeed, the last time core CPI dropped on a monthly seasonally adjusted basis was in July 1980, which proved to be a one-time event.

It's not clear that the negative signs in CPI this time are set for a quick fade. The perfect storm of recession, rising unemployment, a consumer population burdened with historically high levels of debt, the implosion of Wall Street, a housing crisis and a weakening global economy threaten to inject the poison of deflation into the U.S. economy.

It's true that the rapid price decline in commodities is the primary force behind the red ink in prices. That fact provides a bit of hope that deflation may yet be avoided. If falling prices is contained to raw materials, the trend could be dismissed as simply a correction in a formerly high-flying market. Indeed, at some point commodity prices will bottom and prices overall will stop falling. But with the other ills noted above, and the embedded deflationary risk they harbor, the extraordinary news of sharp price tumbles in wholesale and consumer prices can't be ignored just yet.

Another problem is that the Federal Reserve is nearly out of conventional monetary ammunition, and perhaps by more than is generally recognized. The widely quoted target Fed funds rate is at 1%, implying that another 100 basis points of cutting is still possible. But that rate overstates the case. The effective Fed funds rate, which is a better measure of actual transactions between banks and the central bank, is far lower at 0.37%. As such, lowering the 1% target Fed funds, which is likely, will be less of a rate cut than simply facing up to reality as it now stands in the credit market.

Fiscal stimulus engineered by Congress and the White House, along with nontraditional efforts at injecting liquidity by the Fed, are the only levers left. For a number of reasons, including the limited experience of dealing with deflation in the modern era, it's unclear how effective those efforts would be for combating a general price decline.

The good news is that it's still possible to say that deflation hasn't arrived in earnest, at least not yet. On a year-over-year basis, CPI still rose 3.7% through last month. The deflationary warnings have only just arrived, and so we're in the early stages of deciding the broad trend for prices. Hopefully, October's price trends are exceptions, but we'll just have to wait for additional data to be sure. The problem is that if deflation is in fact a real and present danger, acting in a timely manner is essential. Once a deflationary mentality takes hold, there's almost no solution.

Pre-emptive action, in other words, offers the only path for sidestepping the disease. For that reason, erring on the side of stimulus -- a lot more -- looks like a reasonable course. The risk is that it triggers inflation, in which case it'll be time to reverse course. But at least the world knows how to fight inflation. Deflation, by contrast, is an entirely different monster.