Have deflationary forces reached our shore?

Disinflation and deflation are sometimes inadvertently lumped together. The first means a slower pace of inflation (that is, prices are still rising), while the second means an outright decline in the price level.

While many cash-strapped Americans would welcome paying less for what they need to buy-deflation has become the No. 1 fear of a growing number of economists, who worry that lower prices will further hurt the economy. Rarely has the potential for lower prices been so scary.

Deflation was evident in both the Great Depression and the so-called "lost decade" that left Japan with a stagnant economy in the 1990s and earlier this decade.

Just a month ago, Bernard Baumohl, executive director of The Economic Outlook Group, a Princeton, N.J., research firm said that the chance of a deflation is between 10% and 20% for 2009. Now, he is saying that there's a 30% chance of deflation. "The mere concern of a deflationary cycle taking hold can cause it to become a reality. And once you fall into the cycle, it's very difficult to get out."

Producer Price Index (PPI) and the Consumer Price Index (CPI), which measures prices at the wholesale level, showed declines in overall prices for the months of October, November and December. The so-called core CPI was down 0.1% in October and fell a record 1.7% in November. While the consensus forecast is for a 0.1% increase in December. It was the only second three-month period CPI drop in 52 years. Some economists are forecasting the first year-over-year drop in the CPI since 1955. Over the past three months, retail prices have plunged at a 10% annual rate.

It doesn't take much of a price decline to cause economic pain. During Japan's so-called "lost decade" that started in the 1990s, prices only fell by 1% annually. But those deflationary pressures resulted in a prolonged recession. Other economists worry the deflationary pressures are already spilling over into other sectors.

"Those who think this is just about oil, I'd say, stick around and watch. It's going to reach all levels of the economy," said Kevin Giddis, managing director of fixed income at Morgan Keegan.

Lena Komileva, head of G7 market economics for Tullett Prebon, said that “by the time year-over-year CPI does turn negative; policymakers won't be able to respond fast enough to prevent deflation from developing. Deflation is a self-feeding phenomenon and the world simply lacks ability to fight deflation the way it can fight hyperinflation.”

And while the Fed and other central banks are usually able to combat inflation effectively by raising interest rates, there is no simple cure for deflation, especially when interest rates already are near zero as they are in the U.S.

According to a market survey by Tullett Prebon Information, investors are now betting on a 4.25% drop in U.S. prices over the next year, and lower prices lasting for the following three years as well.

Economists worry about deflation because it is a sign of the ever-weakening demand for products. But it can also be a further drag on economic activity by cutting into the willingness of both businesses and consumers to start spending again. Businesses worried that the price of their products may continue to drop would be likely to cut back production. That can lead to additional plant closings and even more job losses. And even consumers who don't lose their jobs are likely to delay purchases, particularly of large amount items, if they think lower prices lay ahead.

Opposing Views

But some economists say recent price declines in the CPI and PPI have been driven primarily by lower oil and gasoline prices. They say that the falling price of one commodity, like oil, can not cause a deflationary cycle, especially at a time that the Federal Reserve and other central banks are pumping so much money into the financial markets. Charles Plosser, president of the Federal Reserve Bank of Philadelphia, dismissed the threat of deflation. "I am not particularly concerned about the possibility of persistent deflation. When oil and commodity prices stabilize, the negative rates of inflation we have seen in the CPI are likely to disappear." he said.

Here are some basic facts. Price declines of the past few months are relatively mild when compared to what happened during the Great Depression. There were year-over-year drops of about 10% every month from March 1931 to April 1933. November's decline in the overall index was largely due to a 17% decline in energy prices and, specifically, a nearly 30% collapse in gasoline prices. However, excluding the food and energy components, the core index was flat for the month, despite a 0.6% decline in new vehicle prices, in line with dismal auto sales numbers reported in the last couple of months by all automakers. Several key categories (apparel, entertainment, medical care, shelter costs) all showed moderate increases, suggesting the absence of any broad-based downward pressure on prices.

By Katherine Marfal