Thursday, September 17, 2009

The Fading Deflation Story

In the immediate aftermath of the Lehman episode last September, two dire predictions quickly entered the mainstream of market psychology: 1) A severe recession was almost inevitable (it had not been officially declared by the NBER at the time, nor was there broad agreement that the economy was already in one), and 2) There was a clear and imminent danger of deflation ahead.

While the first of the above predictions materialized in a manner that became part of the history books, the latter has not come to pass yet, nor is there any persuasive evidence to suggest that it will ultimately do so. In fact, if anything, it is intriguing that the core rate of inflation has shown only a moderate, orderly downward drift by about one percentage point during that period, to 1.4% in the last 12 months leading to August 2009. To be sure, overall CPI has declined by 1.5% from a year ago, but this is almost entirely the result of a 23% collapse in energy prices (highlighting the very limited relevance of that index as a gauge of price trends). Not much going on outside of that, despite a broad-based, massive unwinding of commodity prices in the course of the last year.

Even after the inflation data are put under the microscope, there is no detectable quickening in the last several months of the moderate disinflation trend that has been underway for about a year now. The core rate of CPI inflation has been running at 1.4% in the last three months, while it has been running at a somewhat faster pace in the last six months (1.9%).

Of course, inflation is a lagging indicator, implying that the downtrend may have not run its course yet. Still, in the next 2 to 3 quarters, the disinflationary trend will be confronted by two important headwinds: 1) A significantly improving economic environment compared to the previous 12 months or so, which will act as a natural brake toward any further slowing in the rate of price increases, and, 2) An upturn in import prices, stemming from the roughly 8% depreciation of the dollar since the beginning of 2009. The 6.5% decline in non-petroleum import prices over the last 12 months has appreciably contributed to the slower rate of core inflation during that period but is unlikely to continue moving forward.

The bottom line is that core inflation may still drift closer to 1% over the next 6 to 9 months, but that is still, after all, a long way from zero. For the record, it is worth recalling that the concerns about deflation in this cycle are not that different from those expressed in the early phase of the recovery following the 2001 recession, which had prompted the then Fed Vice Chairman Ben Bernanke to make the infamous by now comments that earned him (unfairly) the nickname "helicopter Ben". Also, for the record, core inflation in the 2002-03 period bottomed out around 1%.

Deflation always makes for a good, scary story. The trouble is that it is much harder to come about.