Smith Faculty Opinion Article - November 15, 2005

Core Producer Prices Fall: Is Deflation the Next Big Challenge?
By Dr. Peter Morici, Professor of International Business

Today, the Labor Department reported the Producer Price Index rose 0.7 percent in October, thanks to rising energy prices.

The report indicates inflation is not spreading to nonenergy goods and services that reach final consumers. The index for finished goods, less energy and food, fell 0.3 percent, and prices for final consumer goods, less energy, were fell 0.2 percent.

The latter two indexes are good predictors of future consumer price inflation. For example, those were up a bit in September, and we can expect an up-tick in the core CPI for October, which will be reported tomorrow.

Going forward, though, consumer price inflation will likely be tame. Gasoline and crude oil prices fell in October and continue to fall in November, and natural gas futures for the heating season continue to moderate. Diesel prices did rise in October but have been falling in November. A warm November bodes well for some moderation in heating costs this winter by extending the stock building season for natural gas and heating oil.

The spurts in energy prices that followed hurricanes Katrina and Rita are subsiding. Rapid productivity improvements are permitting businesses to absorb much of the higher energy and material costs before those reach final consumers. Consider, for example, how many E-tailers are offering free shipping.

Consumers can no longer easily add to credit card debt and home equity loans. Credit card delinquencies are at high levels, and home prices and equity are falling.

With gasoline prices up 35 cents a gallon from a year ago, consumers will cutting back on spending in other areas but not as much as retail analysts predicted. Stores are already discounting to accommodate consumer budgets, and a decent but not exceptional holiday season is likely.

E-tailers like LL Bean began offering free shipping before Halloween. Wal-Mart will not be a bell weather for the industry as it has pursued a risky strategy of stocking higher quality merchandise that it may have to discount more heavily to clear out. A particular bright spot will be home improvement sales, as consumers turn to these projects when the housing market cools and the strategy of selling to buy up becomes more risky.

The core CPI has risen only 0.1 percent or less each month for the last six months, and today's report on wholesale prices indicates future inflation likely will be contained.

The decrease in wholesale prices for final consumer goods less food and energy indicate Federal Reserve concerns about inflation are exaggerated. Coupled with slowing automobile and other retail sales, this cooling of core inflation indicates consumers are strapped, and additional interest rate increases are not needed.

If the Fed persists in raising interest rates, housing prices, which have been falling recently, could collapse. Deflation, not inflation would then be the problem.

Does Alan Greenspan want to leave that legacy to Mr. Bernanke?