No Deflation?

March 17, 2004

The Federal Reserve governors breathed a collective sigh of relief today when the Consumer Price Index showed no deflation. Greenspan & co. have made it very clear they will not tolerate deflation, and have cut interest rates to the lowest level in 40 years to ensure our economy continues to grow. Today's CPI numbers suggest the economy is growing at a slow but steady pace, and that the fears of a Japan-esque deflationary spiral are unwarranted.

I'm not so sure we should count out the deflationary demons just yet.

Inflation is a measure of how much prices as a whole are rising. Perhaps the most significant factor in driving prices higher is the cost of commodities, or raw materials. Logically, if the cost of basic materials rises, the producers of finished goods will raise their prices accordingly in order to maintain profitability.

Commodity prices have been rising significantly over the past year. Crude Oil hit 13 year highs today, steel is skyrocketing, as are the prices of various other industrial metals. Prices should be rising.

But they're not. Why?

Probably because the economy as a whole is shrinking. The extraordinary number of jobs lost during this past recession and "recovery" has put a damper on consumers' buying power. Despite rising costs of inputs, producers cannot raise prices because people simply can't afford to pay higher prices if they're unemployed. The significant inflationary pressure from rising commodity prices is being offset by deflationary pressure caused by unemployment.

Many Fed-watchers are convinced that an interest rate hike is around the corner - the economy is marginally picking up speed, and with commodity prices so high there are legitimate fears of inflation. Rather than assume that inflation is looming, perhaps the Fed should consider the powerful forces that are keeping it in check.