Deflation to hit U.S. next year: CIBC
First time in 50 years
Jacqueline Thorpe
Financial Post

Wim Duisenberg, European Central Bank president, said yesterday he was convinced deflation would not hit the euro zone.

Alan Greenspan, chairman of the U.S. Federal Reserve, has called deflation a "low probability" -- event for the United States.

But a dispassionate crunch of the numbers by CIBC World Markets shows that U.S. consumer prices are set to slide below zero early next year for the first time in 50 years.

"That in itself won't yet add up to a prolonged, Japanese-style deflationary trap," economists Avery Shenfeld and Benjamin Tal said in a new report yesterday. "But as it develops, it will be more than enough to turn what the Fed now calls a 'minor' risk into a 'major worry.' "

Traditional measures show inflation is currently low but not yet below zero.

Consumer price inflation -- the most popular measure -- stands at 2.2% year-over-year.

Excluding volatile energy prices, core inflation is at 1.5% while Mr. Greensapn's favourite indicator, the core personal consumption deflator (pce), flashes at 1.3%.

Speed up the tape a little, however, and things don't look so bubbly. In the most recent six months, the latter two measures are both running at a mere 0.9% annualized clip.

Mr. Shenfeld and Mr. Tal says inflation's disappearing act should not be much of a surprise.

Textbook economics says an economy operating with substantial slack -- low capacity utilization rates and rising unemployment -- will see downward pressure on inflation.

Given that the U.S. economy ended the 1991-2000 expansion with core inflation of just 2.7%, the 2001 recession and ensuing sluggish growth put it firmly on the path to an actual decline in the broader price level.

The rule of thumb is that inflation tends to fall by roughly 1% for each year the economy operating with an output gap of 3%, about where the U.S. output gap sits right now.

CIBC World Markets notes that if it weren't for soaring rents, which carry nearly a 40% weighting in core CPI, that measure would already be close to zero.

The economists add that rents are also more likely to fall than rise in the future with house prices already up 55% and the eight-year-old real estate boom looking tired.

The U.S. could, of course, import inflation by allowing its dollar to fall -- a strategy the Bush administration seems to be following.

This raises import prices and allows American companies to do the same but the economists don't think this will have much of an effect.

"[The] dollar's rise has been too small, import's share of the economy too minor, and the pass-through from exchange prices too modest to offset more than a trivial part of the downward pressure on core inflation," the report said.

The greenback may have slumped against the loonie and the euro but it has only dropped around 8% on the broadest trade-weighted index which includes the pegged Chinese yuan and the Mexican peso.

Imports meanwhile only account for 8.7% of consumer spending so even if the full effect of the 8% depreciation were factored in, the direct boost to core CPI would only be 0.7 percentage points.

Recent experience, including in Canada, has shown that a low currency has not necessarily led to a surge in inflation.

The modest inflationary impact of a depreciating dollar may put a floor under core CPI at 0.5% in early 2004, the economists said.

But with crude oil prices likely near US$25 per barrel, the energy component will push the overall CPI below the core rate and slightly into negative territory in early 2004.

"Even the Bank of Canada seems to acknowledge the inflation story is melting away on this side of the border as well," Mr. Shenfeld added.

The bank said yesterday it was reviewing recent price spikes in insurance premiums to see if they may have been overstated.

The bank raised rates twice earlier in the year to fend off a growing inflationary threat but inflation plummeted to 3.0% in April from 4.3% in March as those price increases and other temporary factors fell out.

"It's hard to believe the Bank of Canada can be worried about inflation when its biggest trading partner is worried about deflation," Mr. Shenfeld said.


Imports account for only a fraction of U.S. consumer spending

Personal consumption of imported goods and services: 91.3%

Personal consumption of domestic goods and services: 8.7%

Source: CIBC World Markets Inc, National Post

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