Low Inflation could Trigger Deflation


Recently, the Department of Labor released the US Producer Price Index, showing that there was a steep drop of inflation during the month of October, as the indicator posted a 2.8% decline in prices; almost a full basis point below analysts’ forecasts. The price drops can be attributed to falling energy prices, gasoline prices, and food prices. The reduction in prices was the larges seen in the history of the index.

As a part of the report, core producer prices, which exclude the volatile energy and food prices rose 0.4%.

The PPI is a Fed favorite for measuring inflation. We can now assume that inflationary concerns have all but vanished in the U.S. economy, possibly setting the stage for further interest rate easing by the Fed.

But markets may have another reason to worry. The combination of continually falling prices and negative returns in equity markets may lead to deflation. A general drop in prices can intensify the global economic downturn. If consumers and businesses estimate prices may continue to decline, they may delay purchases of large ticket items.

Solving the problem of deflation can be a much more difficult task then when dealing with it inflation. To alleviate the pressures of rising prices, the Federal Reserve must raise interest rates, slowing economic expansion until a prices fall. With deflation, interest rates must be cut to stimulate economic growth and force a rise in wages.

Currently the Fed Funds Rate stands at a low of 0.25%. This leaves the Fed very little room to maneuver interest rates in order to raise price levels. Until an economic recovery ensues, the danger of deflation may remain.