Deflation talk is misplaced

All the talk about deflation notwithstanding, the news on prices hasn't changed very much in recent years.

While the headline consumer price index is a prisoner to oil prices, which are subject to Opec's ruminations about production quotas and the changing odds of a Middle East conflagration, the core consumer price index (CPI), which excludes food and energy, has averaged a 2.6% annual increase for the past two years. The year-on-year change has been as low as 2.2% and as high as 2.8%.

Sure, we can ooh and aah at the monthly CPI change, but the bottom line is that nothing much has changed. The hype about the US economy experiencing deflation, or an outright decline in the price level, seems to be based on asset prices, which is where the 'inflation' showed up in the most recent business cycle. This cycle was unique in that it lacked a marked acceleration in the prices of goods and services. Instead, too much money was seemingly chasing too few asset (stock) prices.

Stock prices are into their third consecutive year of 'deflation'. That makes sense: what goes up must come down.

Instead of leaving it at that, people want to extrapolate the deflation in stock prices to the economy at large.

In reality, to paraphrase Nobel laureate in economics Robert Solow, deflation is everywhere except in the numbers. In the past 12 months, the annual CPI increase has been as high as 2.7% and as low as 1.1%. In August, the CPI rose 1.8% from a year earlier.

'People tend to skew their beliefs on the basis of what they experience personally,' says Henry Willmore, senior US economist at Barclays Capital, admitting his conclusion is more 'pop psychology' than economic theory.

For example, consumers focus on the things they buy: autos, with their heavily marketed special promotions (rebates, zero% financing); apparel, where prices have been falling consistently on a year-over-year basis for four years; and computers, the price of which fell 21% in the past 12 months.

'No one really mentions hospital stays, which are indirectly priced, education, which a small part of the population pays, and only for a short period of time, or imputed rent, which is hard to understand,' Willmore says.

Education costs are up 6.4% in the past year. Hospital and related services are up a whopping 8.8% and imputed rent, a category the Bureau of Labor Statistics calls 'owners equivalent rent' and that measures the imputed rental value of a home, is up 3.9%. Somehow, the deflation talk skirts these key service areas.

The press seems to be taken with the idea of deflation, at least until it hits their salaries.

'To judge from the bulk of the articles I read, the proposition that the US economy is experiencing general deflation appears to be widely held,' says Tim Bond, global strategist at Barclays Capital Group in London.

Bond says the typical article begins with the assertion that were it not for medical/rent/housing, whatever index is going up, the economy would be deflating. 'It's not just bad economics,' he complains. 'It's downright stupid.'

Let's look at some more numbers. Core commodities prices have been declining on a year-over-year basis since December 2001. In August, the decline was 0.7%, a little more than half July's 1.3% fall.

Core services, or services less energy services, rose 3.7% in the past 12 months, little changed from a year ago, although down from the peak 4% annual increase of six months ago.

While it is normal for core services inflation to exceed core goods inflation by about two percentage points, 'the divergence between the two has been steadily widening in the past three years and now stands at 4.4 percentage points,' Willmore says.

One reason for the divergence in recent years is increased productivity in manufacturing versus services, he notes. Another is the strength of the dollar, which has more of an impact on the price of goods, which are traded internationally, than services.

'Core inflation has been relatively stable over the past seven years and is likely to remain so next year,' Willmore says.

So, is all the discussion about deflation in the US, even globally, misplaced?

'The analysis of inflation/deflation is spotty and poor,' says Joe Carson, an economist at Alliance Capital Management. 'A change in relative prices is not deflation. It has to do with consumers' tastes and needs.'

Policymakers can't do anything about relative prices but do influence the overall change in prices and the inflation rate, Carson says.

Deflation isn't just a decline in computers, telecommunications equipment and autos. It's a decline in the overall basket of goods and services. Of course, if you whittle away the basket, which is what the BLS has been doing for the past two decades, or swap out one basket for another, which is the effect of the just-introduced chain-weighted CPI, pretty soon there will be nothing left in the basket.

Bloomberg newsroom New York

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