Inflation Or Deflation In The US Economy?

The specter that has been haunting the markets is the specter of deflation. Those concerns have been partially assuaged by the release yesterday of the Producer Price Index (PPI) and of the Consumer Price Index today (CPI). The CPI came in at an increase of 0.4% on a headline basis, following a 0.3% rise in January.

The increase was largely the result of higher energy costs, particularly for gasoline. Prior to these back-to-back increases, the headline CPI had declined for 3 straight months, by 0.8% in December and October, and by 1.7% in November. The fears that we were headed into deflation were clearly not unfounded.

However, those declines were due to the collapse in energy prices. The Core CPI, which strips out volatile food and energy prices, has been low and stable over the past 7 months, never rising more than 0.2% and never actually dipping into negative territory. The core CPI came in at 0.2% in both January and February.

Digging deeper, the housing portion of the index was unchanged for the 3rd straight month. At least this means that rents are not falling on a nationwide basis, and alleviates some of the concerns that investors in Apartment REITs like Apartment Investment (NYSE:AIV) and Mid-America Apartment Communities (NYSE:MAA). If they were, the potential future declines in housing prices would increase.

The “lodging away from home” part is another story. Hotel prices fell 1.8% for the month, and marked the 5th straight decline. This is clearly not good news for firms like Marriott (NYSE:MAR) and Starwood (NYSE:HOT).

So are we out of the deflationary woods?

The PPI data provides mixed signals in that regard. Unlike the CPI, it is reported at several different levels: Finished, Intermediate and Crude. Think of them as Bread, Flour and Wheat.

The finished goods level (”bread”) is the one that is most widely reported in the press, and like the CPI is reported on both a headline and a core basis. Headline PPI rose 0.1% in February, down rather sharply from a 0.8% rise in January. However, prior to January, it had been in a steep decline, with 5 straight negative numbers, including back-to-back 2.6% declines in October and November, and a 1.9% drop in December.

Keep in mind that these are month-to-month changes, not seasonally adjusted annual rates. Thus, those declines are very large indeed.

However, as with the CPI, those declines were mostly due to the path of Energy prices. On a core basis, there has been only one decline in the PPI over the last year, and that was a 0.1% decline in November. In February, core PPI came in at 0.2% following a 0.4% rise in January. Well so far so good - looks like deflation has been avoided, especially when one excludes energy prices.

The problem comes when you look farther back up the chain. At the intermediate goods level (”flour”) prices fell 0.9% in February following a 0.7% decline in January. The February decline marked 7 straight months of falling prices. Even so, the declines were noticeably smaller in the first 2 months of this year than they were in the 4th quarter of last year when they were falling by at least 4.0% per month. Even when you strip out food and energy prices, at the intermediate level deflation seems to have a fairly firm grip. On a core basis, intermediate goods prices have been down for 5 straight months.

The picture is even more extreme at the crude goods level (”wheat”) which is not unusual; crude goods prices are essentially commodities and tend to swing wildly in price. On a headline basis, crude goods are down for 7 straight months, including a 4.5% drop in February which followed a 2.9% decline in January. However, once food and energy prices are stripped away, crude goods rose 1.5% in February following a 0.1% rise in January.

All in all, the low but positive inflation we are seeing is good news for the economy and the markets. It will take a few months to be absolutely sure that the potential deflationary storm has passed, but so far, so good.

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