The two key indicators, the Consumer Price Index (CPI) and the Personal Consumption Expenditure Deflator (PCE), revealed year-on-year inflation of 1.4% and 1.3%, respectively, in January. But before we pop the cork: the recent uptick in inflation owes primarily to the base effect (see box on page 6), which was heavily influenced by the price of oil. And because of the base effect, inflation will drop below 1% from next month through August (see left-hand chart). Will persistently low inflation feed the risk of deflation, where prices fall in all sectors?
A number of factors amply demonstrate that deflation is a real risk:
- The strength of the dollar leads to imported disinflation (see right-hand chart above). This trend is set to last: we expect the dollar to rise slightly by the end of the year, and the USA will remain a net importer of oil and goods.
- Low prices on imported goods – not the result of currency effects but rather of weak global demand and falling inflation worldwide – lead to imported deflation (see right-hand chart above and left-hand chart below).
- Bond market measures of inflation expectations 10 years out are very low, far from the Fed's 2% inflation target (see right-hand chart above). This means that the bond market feels that the drop in oil prices will have a lasting impact on the prices of all goods and services.
These are key factors that must be closely monitored. A long period of deflation can be disastrous for a modern economy with significant debt and must be avoided at all costs. Yet the USA has the economic strength and monetary and fiscal policy tools needed to avoid such a scenario:
Overall domestic demand is very strong in the USA, which favours inflation. (In most cases deflation is accompanied by a collapse in overall demand. Weak consumer spending forces manufacturers to lower their prices and then wages – and the vicious circle commences.) Retail sales, a leading indicator of consumption growth, are robust, with 4% year-on-year growth in January (see left-hand chart below).
Consumer spending has expanded by 3% on average for the past year, and low petrol prices at the pump – 0.48$/litre, which corresponds to a 25% decline over one year – support this trend. Labour market pressures are also on the rise. The latest job creation figures provided a positive surprise, with 242,000 jobs created in February – more than 2.4 times the number needed to absorb new workers on the labour market. The unemployment rate has reached what the Fed considers the equilibrium level (4.9%), and the participation rate on the labour market has risen considerably, reversing the downward trend seen over the past 10 years. This full-employment environment puts upward pressure on salaries and inflation (see right-hand chart above).
2. The current low inflation rate is not consistent with the underlying growth of the US economy. Weak oil prices are distorting overall inflation figures (see chart below).
A more meaningful inflation figure, excluding food and energy, reflects the true strength of the US economy. The Core PCE price index – the Fed's preferred indicator – is up 1.7% year-on-year, very close to the 2% inflation target. The Core CPI is even higher, at 2.2% (see chart opposite). As long as prices are rising in most sectors, deflation should not be a real concern. Core inflation is indeed a sign of a healthy US economy.
3. Lastly, the Fed itself represents a solid pillar of support if deflation were to become a real threat. As Ben Bernanke, the former chair of the Federal Reserve, puts it in his famous paper Deflation: Make sure "it" doesn't happen here (2002), the Fed is responsible for maintaining price stability and therefore must attempt to contain any significant upward or downward movements. "I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank […] has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief." In reality, the Fed is now seeking to gradually 'normalise' its monetary policy in order to avoid a sharp pickup in inflation, which is also finding its way back to normal levels.
At this point, the risk of deflation in the USA is low. Prices are increasing across the board with the exception of oil and commodities prices, which remain low. If the labour market and consumer spending continue on their current path, the deflation scenario will fall by the wayside. We are nevertheless keeping a close eye on the rising risk of deflation in the rest of the world. If strong deflation took root globally, the USA could be dragged down with it.