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Prices are Falling, Prices are Falling!

Given the recent low readings on inflation, it wouldn’t be too surprising to hear warnings of an impending deflation. But is there cause for alarm? A quick examination of the incoming data may help to discern whether it’s time to panic.

The Consumer Price Index (CPI) ticked up a slight 0.8 percent (annualized rate) in March, largely driven by a spike in fresh fruits and vegetables prices (up 72 percent at an annualized rate). Measures of underlying inflation been relatively subdued lately. The core CPI (excludes food and energy prices) was virtually unchanged during the month. In fact, the core CPI hasn’t moved much recently; the index is actually down 0.2 percent over the past three months and up only 0.6 percent over the past six months. The measures of underlying inflation produced by the Federal Reserve Bank of Cleveland, the median CPI and 16 percent trimmed-mean CPI, have behaved similarly. The median CPI was virtually unchanged in March, slipping down 0.2 percent after a 0.3 percent decline in February, and has been flat over the past three months. The 16 percent trimmed-mean CPI increased 0.3 percent in March, somewhat lower than its 6-month growth rate of 0.9 percent.

March Price Statistics

    Percent change, last
    1 mo.a 3 mo.a 6 mo.a 12 mo. 5 yr.a 2008 average
Consumer Price Index
  All items 0.8 0.9 1.7 2.3 2.4 2.8
  Less food and energy 0.5 −0.2 0.6 1.1 2.0 1.8
  Medianb −0.2 0.0 0.4 0.6 2.4 1.2
  16% trimmed meanb 0.3 0.6 0.9 1.0 2.3 1.3

a. Annualized.
b. Calculated by the Federal Reserve Bank of Cleveland.
Sources: U.S. Department of Labor and Bureau of Labor Statistics.

Over a longer time horizon (the past 12 months), the headline CPI is up 2.3 percent, though this largely reflects the path of energy prices. On the other hand, measures of underlying inflation have been slowing. The core CPI is up just 1.1 percent over the period, and the 16 percent trimmed-mean measure has edged up 1.0 percent. Perhaps more striking is that the 12-month growth rate in the median CPI has fallen from a recent high of 3.2 percent in September of 2008 to an all-time low of 0.6 percent (the series goes back to 1968). The longer-term trends in these inflation measures are consistent with a marked disinflation (or a slowing in the rate of price increases) but not a deflationary episode yet.

CPI, Core CPI, and Trimmed-Mean CPI Measures

Perhaps there is something in the component price-change distribution that would give cause for concern. The distribution does reveal a downward shift in retail prices. In March, a majority (56 percent) of the consumer market basket (by expenditure weight) exhibited outright price decreases, compared to 46 percent over the prior three months, and an average of just 20 percent in 2007. Outside of this most recent episode, the last time the share in that lower tail even broached 40 percent was in 2003, and that was only for one month (hitting 45 percent in April 2003). Taking a 6-month moving average (for a smoother trend), reveals that the share of the overall index exhibiting falling prices has risen steadily from a trough near 15 percent in July 2008 to 46 percent in March. However, some prices in the market basket are increasing, and those increases are more than offsetting the price declines in the aggregate (hence, the CPI rose 0.8 percent in March). Roughly 25 percent of the overall index increased at rates greater than 3.0 percent in March, though this is about half as much as a typical month in 2007.

CPI Component Price Change Distribution
Share of CPI Components Decreasing

While the latest readings on underlying inflation are near zero, a significant deflationary episode would likely require rampant and sustained price decreases. Looking forward, it seems that professional forecasters haven’t put much weight on that scenario. The Blue Chip Panel of Forecasters sees inflation rates stabilizing near 2.0 percent by the end of 2011. Even the most pessimistic bunch (the bottom-ten average) does not see deflation on the horizon. They expect retail prices to hover a little under 1.0 percent over the forecast horizon.

CPI and Forecasrs

In summary, a brief look at retail prices shows that the underlying inflation rate has slowed significantly over the past year or so, but a significant deflation has yet to materialize. Moreover, inflation expectations (from forecasters at least) seem relatively stable, which is important. If people expect future prices to be lower than today’s prices, that would likely influence their behavior today, and deflation would become a self-fulfilling process. So far, it doesn’t seem like that has happened.

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