Inflation's slowdown has many economists worried
By Barbara Hagenbaugh and Sue Kirchhoff, USA TODAY
WASHINGTON — With price increases running at the slowest pace in decades, deflation has become a bigger threat to the struggling U.S. economy.
But many economists say the danger of widespread price declines, which undoubtedly would bring the economy back into recession, is still extremely small.
After rising 1.7% in 2002, inflation is increasing less than 1% this year, according to the government's personal consumption expenditure price index. The gauge, favored by the Federal Reserve, tracks prices based on consumer spending, excluding volatile food and energy costs. That measure hasn't been under 1% since 1949.
The inflation drop has been led by slower gains in costs of medical care, which have risen in double-digit proportions in recent years; long-lasting durable goods, which include furniture and computers; and homes.
Such data led Fed officials to warn Tuesday that a "substantial" inflation drop from the current level was possible, although they deemed the chances of that happening as "minor." Private economists agreed with the Fed's assessment, pointing to rising prices for some raw materials, a fall in the value of the dollar and expectations for stronger economic activity later this year, all of which historically have led to price gains.
Lakshman Achuthan, managing director of the Economic Cycle Research Institute, says the group's gauge of future inflation has begun to fall after swiftly rising last year and into the early part of 2003 but still points to further price gains, not declines. The measure looks at a host of inflation indicators, including commodity prices.
Despite expectations deflation won't happen, Fed officials are wise to be cautious in light of the recent experience in deflation-mired Japan, economists say. That has shown falling prices can be harder to combat than inflation and can cause serious harm to an economy. The Fed has carefully studied the experience in the world's second-largest economy, which has been in and out of a recession for more than a decade.
U.S. "inflation is not zero, and it probably won't go to deflation, but it wouldn't take much bad luck to be there," J.P. Morgan senior economist James Glassman says. "And that's the problem. You don't ever want to be there, and Japan is showing you why."
While lower prices are initially cheered by consumers, over time they cause problems:
Profits. Companies are unable to raise prices to offset costs, which have gained recently largely due to increased health care and insurance premium costs. That cuts into profits, potentially forcing firms to cut workers and wages to stay afloat. That, in turn, can lead to declines in spending, leading to a downward spiral that's hard to stop.
Debts. When firms' and consumers' incomes decline, it becomes harder to make loan payments. That can lead to a decline in spending and may lead to bankruptcies.
Shopping. When prices are falling, consumers and businesses may put off purchases in expectation prices will fall more. That leads to a stall in purchases and in the overall economy.
The Fed. Fed policymakers need to be able to reduce interest rates below the rate of inflation to pump life into the economy in bad times. If rates are below the rate of inflation, borrowing money becomes too attractive to pass up, which in turn spurs spending. For example, if inflation were to run at 2%, and the Fed cut rates to 1%, interest rates would be below the inflation rate. When inflation is falling, it's more difficult to achieve that goal.
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