Deflation In The US?

This morning’s (Thursday) US Producer Price Index (PPI) release is additional evidence that we are on the cusp of deflation. This is a remarkable turnaround from just a few months ago. In December the Producer Price index fell by 1.9%, following a 2.2% decline in November. It was the fifth straight month of declines.

On a year-over-year basis, producer prices are now down 0.9%, a dramatic decline from its up 9.9% peak in July. Things are not quite so dramatic once you strip out food and energy prices to get to the core PPI. It rose 0.2% in December after a 0.1% rise in November. In December, Food prices were down 1.5%. However, the real story was the continuing decline in energy prices, which fell 9.3% in December following declines of 11.2% in November and 12.8% in October.

All of these numbers refer to the prices of finished goods, but the numbers are released for three levels, Finished (bread), Intermediate (flour) and Crude (wheat). The price declines get more dramatic as you go farther back in the production chain. Intermediate goods prices fell 4.2% in December following declines of 4.3% in November and a 3.9% decline in October.

Crude goods fell even further, but the rate of decline is slowing markedly, down 5.3% in December vs. a 12.5% decline in November and a 18.6% decline in October. Trends in the lower levels of production do eventually tend to bleed through to the finished goods level, but they are almost always more volatile.

Tomorrow we will see if deflation has yet reared its head at the Consumer Price (CPI) level. Most Central Bankers and Economists really do not like deflation, and see the ideal situation to be very low and stable positive inflation, between 1% and 2%.

Since interest rates can not decline below zero (at least for any significant amount of time — we have actually seen negative rates on the 3 month T-bill recently, but that is just plain weird and a sign of extreme distress in the financial markets) falling prices raises real interest rates and the traditional tools of Central bankers (changing short term interest rates) do not work very well.

Deflation also tends to slow economic activity. Think about is as a bear market in the market for goods and services. When the markets are falling fast, many investors don’t want to “catch falling knives.” They say, “Sure XYZ Corp. looks cheap here, but why should I buy it at $20 a share when it looks like it could go much lower?”

Falling prices in the real economy tends to induce the same sort of behavior. Why buy a car now if you think that the car companies are going to come out with even bigger rebates in the near future?

This further slows the velocity of money. Remember, nominal GDP is equal to the money supply times the velocity of money. Falling velocity is a VERY serious problem. Central banks then have to offset this by increasing the money supply, but the traditional way of doing that involves cutting short-term rates, like the Fed Funds rate.

However, it is impossible to cut rates if they are already at zero. Thus, Central Banks have to resort to more “creative” ways of increasing the money supply, and that usually involves the Central Bank taking on more risk, either buying non-government paper or buying longer dated securities.

The Fed has already started going down that path.

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