Is Deflation the Real Problem?

From the FT:

There is a growing risk that deflation will be seen as the gravest threat to the US economy by the end of the year, warns Nick Beecroft, senior FX consultant at Saxo Bank.

He notes that the minutes of last month’s Federal Reserve policy meeting show the US central bank becoming increasingly concerned with the fall in inflation.

And the latest consumer price data will have reinforced these worries, he says. “As the year progresses, the output gap – exemplified by the still chronically weak labour market and very low levels of capacity utilisation – will lead inflation inexorably towards zero.”

Here are some important excerpts from the latest FOMC Minutes:

Meanwhile, a sizable increase in energy prices pushed up headline consumer price inflation in recent months; in contrast, core consumer price inflation was quite low.

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Although rising energy prices continued to boost overall consumer price inflation, consumer prices excluding food and energy were soft, as a wide variety of goods and services exhibited persistently low inflation or outright price declines. On a 12-month change basis, core personal consumption expenditures (PCE) price inflation slowed in January 2010 compared with a year earlier, as a marked and fairly widespread deceleration in market-based core PCE prices was partly offset by an acceleration in nonmarket prices. Survey expectations for near-term inflation were unchanged over the intermeeting period; median longer-term inflation expectations edged down to near the lower end of the narrow range that prevailed over the previous few years. With regard to labor costs, the revised data on wages and salaries showed that last year's deceleration in hourly compensation was even sharper than was evident at the January meeting.

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Headline consumer price inflation picked up around the world over the past two months, principally reflecting increases in food and energy prices. Excluding food and energy, consumer prices were generally more subdued.

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Reflecting these developments, inflation compensation--the difference between nominal yields and TIPS yields for a given term to maturity--declined over the period, a move that was supported by the somewhat weaker-than-expected economic data and the publication of lower-than-expected readings on consumer prices.

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Recent data on consumer prices and unit labor costs led the staff to revise down slightly its projection for core PCE price inflation for 2010 and 2011; as before, core inflation was projected to be quite subdued at rates below last year's pace. Although increased oil prices had boosted overall inflation over recent months, the staff anticipated that consumer prices for energy would increase more slowly going forward, consistent with quotes on oil futures contracts. Consequently, total PCE price inflation was projected to run a little above core inflation this year and then edge down to the same rate as core inflation in 2011.

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Participants saw recent inflation readings as suggesting a slightly greater deceleration in consumer prices than had been expected. In light of stable longer-term inflation expectations and the likely continuation of substantial resource slack, they generally anticipated that inflation would be subdued for some time.

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Participants referred to a wide array of evidence as indicating that underlying inflation trends remained subdued. The latest readings on core inflation--which exclude the relatively volatile prices of food and energy--were generally lower than they had anticipated, and with petroleum prices having leveled out, headline inflation was likely to come down to a rate close to that of core inflation over coming months. While the ongoing decline in the implicit rental cost for owner-occupied housing was weighing on core inflation, a number of participants observed that the moderation in price changes was widespread across many categories of spending. This moderation was evident in the appreciable slowing of inflation measures such as trimmed means and medians, which exclude the most extreme price movements in each period.

In discussing the inflation outlook, participants took note of signs that inflation expectations were reasonably well anchored, and most agreed that substantial resource slack was continuing to restrain cost pressures. Measures of gains in nominal compensation had slowed, and sharp increases in productivity had pushed down producers' unit labor costs. Anecdotal information indicated that planned wage increases were small or nonexistent and suggested that large margins of underutilized capital and labor and a highly competitive pricing environment were exerting considerable downward pressure on price adjustments. Survey readings and financial market data pointed to a modest decline in longer-term inflation expectations over recent months. While all participants anticipated that inflation would be subdued over the near term, a few noted that the risks to inflation expectations and the medium-term inflation outlook might be tilted to the upside in light of the large fiscal deficits and the extraordinarily accommodative stance of monetary policy.

This is something we'll be talking about more next week after looking deeper into the data.