Inflation or deflation? For interest rates, it matters

Posted: Friday, January 02, 2004

NEW YORK (AP) No sooner did the Federal Reserve seemingly back away from its worries over deflation than new economic data revealed that core consumer prices fell this fall for the first time in 21 years.

That's making it all the more tricky to figure out where prices are heading next and which direction they go matters because prices are sure to have a big influence on the Fed's next move with interest rates.

An upturn in prices could mean rates will rise soon, while signs of falling or stable prices could keep them low for some time.

Confused yet? Don't worry, even economic experts are baffled.

Since World War II, the Fed has largely tried to keep inflation in check. But deflationary concerns took center stage starting last spring after the Fed said the probability of dropping prices exceeded that of rising prices.

When a destructive deflationary cycle takes hold, consumers stop spending because they think even better deals are on the way. Then businesses make deep price cuts to attract customers, and that eats away at profits.

The good news is we haven't gotten stuck in such a mess at least yet. And recent comments from the Fed indicate that its central bankers believe the threat may be over.

After its December policy-making committee meeting where it left a key short-term interest rate at a 45-year low of 1 percent, the Fed issued a statement that said the prospect of inflation going lower had diminished and was now about equal with the possibility that inflation could increase.

Certain sectors of the economy are already experiencing inflation. Look at the steep gains in commodity prices, with the Commodity Research Bureau's spot index soaring 16 percent over the last year, while gold prices have surged above $400 for the first time since the mid-1990s. Medical care and education services are also sharply higher.

The weak dollar could also be inflationary. Non-oil import prices are now rising modestly, climbing 1.1 percent in November compared with a year earlier, when they had dropped slightly. And OPEC said earlier this month that it may cut production to protect itself from the falling dollar, which could boost oil prices.

Of course, the Fed doesn't want inflation to go too high. About 3 percent would suit it just fine, enough to keep the economy's engines going by giving businesses some pricing power back.

''Fed officials have made it clear that they want to push inflation up and that they are not inclined to tighten monetary policy until they have succeeded in that endeavor,'' Goldman, Sachs & Co. chief U.S. economist William Dudley pointed out in a recent note to clients.

But that may take longer than anticipated.

Just days after the Fed changed its stance on deflation, the Labor Department issued a surprising report that showed the consumer price index, the government's widely followed measure of inflation, fell 0.2 percent in November. That pulled the year-over-year pace down to 1.8 percent from 2 percent.

And the core rate of inflation CPI subtracting out the volatile food and energy categories was off 0.1 percent, its first drop since December 1982.

In addition, 40 percent of the components in the core CPI are flat or negative from a year ago, according to David Rosenberg, chief North American economist at Merrill Lynch. That includes an 11.3 percent slump in used car prices, which are deflating at a pace not seen since February 1961. Apparel and furniture prices were also down.

So where does that leave us?

The CPI report suggests the Fed has leeway to keep rates low, possibly into 2005. That's good news for business and consumer spending, which could be dampened should rates go up.

But there is also the possibility that the drop in the November prices may just be an anomaly, so economists and investors are sure to closely watch when the December figures are reported in the middle of this month.

That may give a better clue into the Fed's next move, or lack of it.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)

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