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Inflation falls, but deflation poses small risk

Over the past year, the Fed has made clear its intention to "reflate" the economy, cutting its benchmark federal funds rate in June to 1 perent, the lowest level in 45 years.
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It was just over a year ago when Federal Reserve Gov. Ben Bernanke delivered a watershed speech on deflation, signaling that the central bank’s long battle against rising prices was over and that a new front had been opened. Bernanke said deflation — a steady persistent decline in prices that can accompany painfully slow economic growth — was not likely in the United States. But because a deflationary downturn could be so devastating and so hard to reverse, he suggested the Fed needed to preserve a “buffer zone” for inflation rather than allowing it to drop all the way to zero.

Since then the Fed has made clear its intention to “reflate” the economy, cutting its benchmark federal funds rate in June to 1 percent, the lowest level in 45 years. With the added tailwind of a federal tax cut, a wave of mortgage refinancing and a depreciating dollar, the economy has responded with its strongest growth in nearly 20 years.

Yet the inflation rate has moved steadily lower, with the closely watched core rate — which excludes food and energy prices — dropping from 1.9 percent a year ago to 1.1 percent, the lowest level in 38 years, according to government data released this week.  With the economy  poised for strong growth next year, the threat of deflation appears to have passed, economists say. But the Fed certainly doesn’t have much of a buffer zone.

Forecasters are divided over whether the economy is likely to face a significant increase in inflation next year. Many analysts expect the expanding economy to result in substantial job growth over the next several quarters, enough to get inflation back on the radar screen and force the Fed to raise interest rates by midyear. Diane Swonk, chief economist for Bank One, sees a midyear increase of a half-point in the fed funds rate “as a credibility move against inflation,” with more “heavy lifting” on rates in 2005.

But others expect the Fed to remain on hold through 2004 and into 2005, saying the substantial amount of slack in the nation’s factories and labor forces mean that inflation is unlikely to move much over the next year.

“In our view, the factors pushing inflation lower are at least as important as the factors pushing inflation higher,” Goldman Sachs chief economist Bill Dudley said in a note. “Our view (is) that the core measures of inflation will remain broadly unchanged in 2004, with the risks on inflation mainly to the downside.”

Ethan Harris, chief U.S. economist for Lehman Bros., pointed out that inflation normally declines in the first year of a recovery due to excess capacity that has built up during the downturn. Technically the United States has been in recovery mode since November 2001, but the economy did not really take off until mid-2003.

“I think that inflation is likely to remain pretty much where it is right now for the next year,” he said. But with the economy growing robustly, Harris said there is little danger of deflation.

“As long as the recovery continues and there’s a gradual healing in  the economy the risk of deflation is very  low,” he said. “It really would require  some ugly event that drives us back into recession at this stage to actually create deflation.”

John Silvia, chief economist of Wachovia Securities, argues that there is more inflation in the economy than is apparent from the core rate that is the preferred measure of the Fed. The core rate might have been important in the 1970s and ‘80s, when food and energy prices were particularly volatile, he said, but that is no longer the case.

“The reality of it is that food and gasoline prices are rising,” he said. “This is not volatility — this is a trend. They are rising on a regular basis. I think the whole core concept is really misleading at this point in the business cycle.”

Indeed retail food prices are up 3.1 percent from a year ago, led by an 11 percent increase in the price of meat, poultry fish and eggs, according to the government’s Consumer Price Index. Household energy prices are up 7 percent and gasoline prices are up 5.5 percent. The costs of education and health care also are rising, with tuition up 7 percent and hospital costs up 6.5 percent.

But the prices of some consumer goods have fallen including apparel, down 2 percent, new cars and trucks, down 2 percent, and used vehicles, down 11 percent.

Dudley, of Goldman Sachs, argues that energy prices are likely to fall this year, a forecast reflected in energy commodity prices. And hourly wages have risen only 2.1 percent in the 12 months, down from a 3 percent pace seen earlier this year.

Mark Zandi, chief economist of, said growth in wages is the key piece to the inflation puzzle.

“If wages and compensation growth are low ... it’s unlikely we’ll see any broad inflation,” he said. But he said it is “very reasonable” to assume that over the next several years the Fed will once again have to turn its attention to rising inflation.

“The Fed is bent on getting inflation to accelerate,” Zandi said. “At some time we will see an increase — if not in the next year then in the next couple of years. Inflation is in all likelihood not going lower.”