The Financial Mess Has One Bright Spot: No Inflation

The Financial Mess Has One Bright Spot: No Inflation

Even though the outlook is brightening, the U.S. economy is still struggling with a host of problems — a jobless rate of close to 10 percent, millions of pending home foreclosures, dozens of smaller failing banks, a huge federal budget deficit and strapped state governments among them. Notably, inflation is not on the list.

Consumer prices increased a scant 1.1 percent in the past year, according to the Labor Department. Excluding volatile food and energy items, core prices rose even less, 0.8 percent.

It may be small comfort for American households whose income has plummeted because of a lost job, but at least the cost of living hasn’t climbed. Moreover, most economists are predicting that inflation will remain very low, and perhaps fall further, during the coming year or two.

Ian Shepherdson, chief U.S. economist for High Frequency Economics, actually was relieved that the core CPI had ticked up to 0.1 percent last month after three consecutive months of no change had left the year-over-year increase at only 0.6 percent.

"Had the run of zeros continued for much longer it would have been hard to argue that the trend remained positive," Shepherdson said. "Deflation would have been just a rounding error away. As it is, a 0.8 percent year-over-year core inflation rate is hardly comforting, and we have no confidence that the absolute low for the cycle has passed."

Deflation, a broad decline in the overall level of prices, can make debts hard to repay and discourage both consumption and business investment because of expectations that goods and services will be cheaper in the future. It is a condition that has plagued the Japanese economy for years, and with that example in mind, Federal Reserve officials are intent on making sure it doesn't happen here.

Fed Chairman Ben S. Bernanke has said he and his colleagues don't expect deflation to hit the United States, but the possibility was one reason they decided last month to purchase $600 billion worth of longer-term Treasury securities between then and the middle of next year. The point was to reduce longer-term interest rates, which fell after Bernanke signaled the move was on the way back in August. Since the Nov. 3 decision, longer-term rates have moved up rather than down, largely because of the prospect for stronger economic growth due to expected stimulus from the tax bill moving through Congress and to the Fed action — not because of a sudden fear of higher inflation on the part of investors.

"This is the golden age of price tranquility," said Key Mayland of ClearView (sic) Economics. "Although business is expanding, there is also substantial excess capacity relative to demands that make price increases for consumer goods and services difficult to achieve." But Mayland also cautioned, "'Golden ages' do not last forever. As demands recover and raw material cost pressures bubble up the supply chain, sellers will regain some pricing power."

That's sometime in the future. For now, he asked, "Got the itch? It is now a better time to buy a car. New car prices fell 0.4 percent last month, after declining 0.2 percent in October, and used car prices have retreated significantly for three straight months."

As Mayland noted, some commodity prices have gone up, including oil, with gasoline prices at the pump following suit. But for most industries, by far the largest cost is that of labor, and that is not really going up at all.

For the year ended in the third quarter, hourly compensation for workers in the non-farm portion of the economy rose only 1.4 percent. Over the same period, productivity — the amount of goods and services produced for each hour worked — was up even more, 2.5 percent. The result? A decline in unit labor costs of 1.1 percent. In the manufacturing sector, productivity climbed even faster and unit labor costs fell 2.9 percent.

Meanwhile, with labor costs under such tight control, corporate profits reached 11.24 percent of gross domestic product in the third quarter, only about a percentage lower than they were before the financial crisis hit in 2007 — and otherwise the highest since the late 1960s.

How fast this situation might change depends in large part on how fast unemployment falls and employers begin to raise wages to attract needed workers. Goldman Sachs economist Sven Jari Stehn said in a memo sent to his firm's clients that Goldman's forecast indicates that's going to be quite a slow process. As a result, the question is "whether core inflation falls further or remains broadly unchanged over the next two years," he said.

A key reason core inflation is so flat is that the cost of shelter, particularly rent of primary residences and the so-called owners' equivalent rent for the imputed cost of living in your own home, have been depressed by the troubled housing market. Those might be about to turn, Stehn said. But otherwise, the Goldman econometric models "suggest a range of 0-1 percent for core inflation between now and the end of 2012."

With stronger growth, which some other forecasters, such as those at Macroeconomic Advisers are expecting, joblessness and spare productive capacity would shrink faster and push up core inflation at least modestly — exactly what Bernanke and other Fed officials would like to see; but it’s something that is extremely difficult to explain to the public.

In the meantime, because the prices are right or for some other reason, the recent retail sales figures suggest a lot of consumers are following Ken Mayland's advice. They're out there shopping.