Deflation Ahead? No Worries

Although prices fell in June for the third consecutive month, deflation is unlikely to persist. Special factors have been in play, and the outlook remains one of very low inflation, not falling prices.

This latest dip in prices brings the inflation rate for the past year to a meager 1.1%, with prices flat -- technically, down 0.1% -- over the first half of 2010. While this may be raising worries about persistent deflation, alarm isn’t warranted. The reason has to do with energy prices and the process of adjusting reality for seasonal patterns.

Specifically, energy prices have a pattern of rising over the first half of the year, mostly because people drive more during the summer and the elevated demand for petroleum products tends to boost prices. In an attempt to wring out this temporary seasonal aberration, the government agency responsible for posting monthly inflation reports presents figures that are “seasonally adjusted.” But this year, energy price increases haven’t matched their usual climb. Gasoline prices, for example, typically climb 14% over the first half of the year. This year, they increased only 4% over that period. With a seasonal adjustment, that translates into a 10% decline. Consumers don’t actually see that decline at the pump, of course, which is why they’re sometimes puzzled by economic reports indicating price decreases.

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The usual seasonal pattern would have gasoline prices falling a whopping 19% in the second half of the year. So if they actually decline 10%, as we expect, that will translate into a seasonally adjusted gain of 9%, and the price weakness reported over this year’s first half will be largely reversed. All this is one reason economists prefer to focus on measuring “core” inflation, which strips out volatile food and energy prices.

On a core inflation basis, prices have continued to rise, albeit modestly. Core inflation is up 0.9% over the past year and 1.1% year-to-date. Going forward, we expect more of the same, perhaps with some further softening toward year-end. The reason: Persistent slack in the economy is restricting price increases. In housing, for example, a glutted rental market (and the fact that rents tend to reflect market conditions with about a six-month lag), will keep a lid on core inflation more generally.

But deflation at the core level, at least on a sustained basis, remains unlikely. The economy is gradually taking up its slack (e.g., unemployment is falling, not rising), which leads us to believe that inflation will rise somewhat but remain very low next year.