Monday, March 28, 2016

Deflation worries are not over

A jump in the core U.S. inflation rate has persuaded many people that deflation is no longer a threat. But even those who never subscribed to the idea that consumer prices might decline for a sustained period should be wary of misreading the data and dismissing the risk of deflation.

When prices rise, people think the devil or other forces outside their control are at work. But when they pay less, it’s because they’re smart shoppers.

Consumers (and even economists) also aren’t aware that there's deflation in goods prices. In December 2015, the goods component of the inflation index fell 2.2 percent. Furthermore, U.S. consumers aren’t spending the windfall from lower gasoline prices and thereby spurring the economy and prices.

There’s also a link between the prices of goods and the costs of services, so the annual inflation rate for services has declined to 1.9 percent in December from as high as 2.5 percent in May 2014. (Laid-off oil field workers don’t take as many vacations; they frequent bars and restaurants less often.)

In addition, inflation worriers tend not to look beneath the headlines to acknowledge that the CPI measure considerably overstates inflation. Many quality improvements aren’t reflected in prices, despite what are called hedonic quality adjustments designed to capture improved performance. A new laptop, for example, may cost the same as its predecessor but have 10 times the computing power. Also, the CPI has fixed weights and doesn’t reflect the fact that when oranges are cheaper than apples, people buy more oranges.

So, in my judgment, deflation remains not just possible but probable..... And this matters because the value of the consumer price index reverberates through the economy, ranging from cost-of-living assessments to the returns on U.S. government inflation-linked debt to how the Federal Reserve shapes monetary policy.