Kurt Brouwer November 18th, 2008
In those halcyon days before Hank Paulson, TARP, subprime and credit default swap became household words, there was widespread concern about inflation. Though it seems like a distant memory, it was only five or six months ago that inflation was soaring along with oil, food and other commodities. Oil hit $146 per barrel and gasoline was north of $4 a gallon.
This is an interesting chart in that it illustrates the inflation-adjusted price for a gallon of since 1980.
Source: Carpe Diem
Earlier this year, the news was full of stories about the inevitable trend towards higher and higher gas prices. Yet now, gasoline prices are falling and from this chart we can see that we are paying the same cost for gas that we were paying 28 years, once inflation has been factored in. Actually, our gas bills are probably lower because cars generally have better mileage today than they did back then.
With falling prices for energy and other commodities, inflation is no longer as visible a concern as it was earlier this year. In fact, the pricing of TIPs (Treasury Inflation Protection) bonds reflects a most benign view of future inflation — slim to none. What a difference a few months makes (see Inflation Falls In August). But, with shares in the stock market plummeting, real estate prices falling, bond prices down along with commodities, another specter has arisen — deflation.
Inflation means that we are experiencing a general increase in the price of goods we buy. Deflation is the opposite, that is, a general decline in the prices of the goods we buy. Inflation is very common in most developed countries, but deflation is rare. The last time we had protracted deflation was in the Great Depression of the 1930s.
We have often seen asset deflation in a particular market such as stocks from 2000- 2002. But, we very seldom see deflation across the range of most assets — stocks, bonds, real estate, commodities and so on. However, that is exactly we have in front of us now. And, that’s why, this financial panic and economic downturn is frequently linked to the Great Depression because we have seen wholesale asset deflation over the past year or so just as we did back then.
Recently, we have also begun to see declines in the cost of living. That is, in August and September, the Consumer Price Index (CPI) actually went down slightly. As a sign of things to come, we are also seeing falling wholesale prices due to declining demand. With falling wholesale prices, we can infer that we will see declining inflation in the months to come. This piece from AP gives some details [emphasis added]:
October Wholesale Prices Plunge Record 2.8 Percent (Real Clear Markets / Associated Press, November 18, 2008, Martin Crutsinger)
…The Labor Department reported Tuesday that wholesale prices dropped by 2.8 percent in October, the biggest one-month decline on records that go back more than 60 years. The previous record holder was a 1.6 percent fall in October 2001, the month after the terrorist attacks.
The overall decline in the department’s Producer Price Index was bigger than the 1.8 percent drop analysts had expected. However, core inflation, which excludes energy and food, was not as well-behaved, rising by a bigger-than-expected 0.4 percent.
The 0.4 percent rise in core inflation did not alter the view that plunging energy prices and a sharply slowing economy were combining to slash inflation pressures.
Analysts said much of the jump in core prices reflected the lingering impact of the huge rise in energy costs earlier in the year and should retreat in coming months as those costs continue to fall.
Ian Shepherdson, chief U.S. economist at High Frequency Economics, predicted that core wholesale prices would retreat significantly in coming months.
The 2.8 percent overall decrease marked the third straight month that wholesale prices have fallen.
What we are witnessing is the stark beauty of markets behaving in ways that make economic sense. If demand is falling, those who make and sell goods reduce prices. At some point, those lower prices become tempting and businesses and consumers begin buying again. In other words, deflation is not all bad. Computer prices have been falling for many years and consumers have really benefited. We have seen sharp declines in the cost of telephone calls and cell phones and many other electronic goods. Now, the slumping economy has weakened demand enough that, at least, most goods and services are under some pricing pressure. As a result, overall inflation has fallen slightly.
Keeping prices stable is a primary function of the Federal Reserve. Generally, that means holding the rate of inflation in the Fed’s preferred range of 1-2% per year. That moderate rate of inflation seems to be what the Fed believes will work best given the Fed’s other mission, which is to also seek full employment. Earlier this year, the rate of inflation cranked up quite a bit higher than the Fed would have liked and that presented a series of problems.
As awareness of higher inflation increased, the Fed was suddenly faced with a different and starkly different set of problems caused by falling asset prices. Home prices have been declining since late 2006 or early 2007, but the decline accelerated. Falling real estate prices exacerbated problems mortgage securities and the impact of cratering prices for mortgages filtered through the financial markets and stocks and bonds began losing value. Finally, over the summer, energy prices ran out of steam and began falling.
The AP piece continues:
The PPI report showed that energy prices dropped by 12.8 percent in October, the biggest one-month fall since a 14 percent decline in July 1986.
All types of energy showed big declines with gasoline falling by a record 24.9 percent, surpassing the old mark of a 22.1 percent drop in March 1986.
Home heating oil prices were down 9.6 percent, natural gas intended for home uses fell by 5.9 percent, and liquefied petroleum gas dropped by 27.6 percent, the biggest decline in more than three decades.
Light, sweet crude for December delivery rose slightly Tuesday morning after falling $2.09 to settle at $54.95 a barrel Monday, the lowest since January 2007. Prices have fallen more than 60 percent since reaching a record above $147 a barrel in mid-July.
Food costs edged down 0.2 percent last month, as declines in the price of milk and meats offset a big jump in vegetable prices.
Update: As noted above, the trend for consumer prices is lower and lower. This piece from the Associated Press makes the point [emphasis added]:
Consumer prices plunged by the largest amount in the past 61 years in October as gasoline pump prices dropped by a record amount.
The Labor Department said Wednesday that consumer prices fell by 1 percent last month, the biggest one-month decline on records that go back to February 1947. The drop was twice as large as the 0.5 percent decline analysts expected.
…The big drop in inflation reflected not only a huge fall in gasoline and other energy costs, but widespread declines in other areas. Core consumer prices, which exclude food and energy, fell by 0.1 percent last month, the first drop in core prices in more than a quarter-century.
There were price declines for clothing, new and used cars, and airline fares. Analysts predicted further declines in the months ahead as retailers struggle to attract consumers who are being battered by rising unemployment and the weak economy.
…The big retreat in consumer prices represented a remarkable turnaround from just a few months ago when a relentless surge in energy prices raised concerns that inflation could get out of control…
Falling prices for consumer goods mean that people have a little more money in their pockets than they would have had if prices stayed high. For example, I have seen several estimates of the annual savings we obtain from each decrease in gas prices of one penny. As I understand it, each one penny reduction in gas prices saves Americans well over $1 billion per year.
As the average price is down by about $2 from the high point of $4.12 or more, I estimate that the annual savings will be somewhere between $200 and $300 billion.
Falling consumer prices are a good thing, but there are concerns about generalized falling prices, i.e. deflation. A generalized state of deflation is viewed with fear and loathing by most economists because it can be very disruptive. As a result, the Fed is working hard to inject cash and capital into the system to help stem the losses at financial institutions. The net result of all these attempts is to inject vast amounts of liquidity into the financial system, which generally means — you guessed it — higher inflation down the road.
For now, consumer prices are falling, but the seeds of inflation are being planted in an effort to avert deflation.
