What makes deflation such a dreaded condition

Deflation is an empty threat (so far)
In such a deep recession, the word is bound to come up. But a close look at the numbers shows that it's a long shot at this point.

Anthony Karydakis, Contributor
December 18, 2008: 9:37 AM ET

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This recession has been so unusual that it has brought back economic phenomena that haven't been seen in generations, at least not in the U.S. Chief among them is deflation. It's a scary prospect that has been on people's minds since evidence of a deepening recession started proliferating quickly earlier in the fall.
What makes deflation such a dreaded condition is that, once it takes hold, it motivates consumers to hold back on spending in the expectation that they will be able to buy things at a cheaper price later. This causes further drop in demand today, leading to more cutbacks in production and even slower economic activity, which feeds into more price declines -- a highly destabilizing dynamic.
Against that backdrop, the report earlier this week on November's Consumer Price Index (CPI) was eagerly anticipated, as it was likely to shed some light on whether such deflation fears are realistic in this environment. The anxiety over such a prospect had already been heightened by a sizeable decline (-1.0%) in the index in October and a highly unusual drop (-0.1%) in the so-called "core" CPI that month. (Core CPI is the overall index minus the notoriously volatile components of food and energy, which together account for about one-fourth of the total.)
So, with the stakes so high for the November report, what was the verdict?
On the face of it, the sharp 1.7% decline in the CPI last month (its biggest monthly drop ever and its fourth consecutive one since August) added fuel to the concerns that the economy may be about to get hit by powerful deflationary forces. Adding to that impression, the CPI is now up only 1.1% in the last 12-month period, while it was up by 3.7% in the 12-month period to October and 5.6% in the corresponding period to July.
So, there is no doubt that a major downtrend in the rate of inflation is already manifesting itself in strong terms. It is important, though, to draw a sharp distinction between the terms "disinflation" and "deflation," which are sometimes inadvertently lumped together. The first means a slower pace of inflation (that is, prices are still rising), while the second means an outright decline in the price level.
However, before jumping to the conclusion that deflation is around the corner, it's important to consider several factors that present a significantly less bleak picture.

Let's begin with some basic facts:
November's decline in the overall index was largely due to a 17% decline in energy prices and, specifically, a nearly 30% collapse in gasoline prices. However, excluding the food and energy components, the core index was flat for the month, despite a 0.6% decline in new vehicle prices, in line with dismal auto sales numbers reported in the last couple of months by all automakers. Several key categories (apparel, entertainment, medical care, shelter costs) all showed moderate increases, suggesting the absence of any broad-based downward pressure on prices.
So the inflation downtrend since July is largely the result of a dramatic decline in commodity prices (and particularly energy prices) and to a lesser degree the rebound of the dollar and the pullback in consumer demand. Looking ahead, it appears that the pace of erosion in commodity prices is slowing and the dollar's rebound is stalling, as the perceived depth of the U.S recession is raising some anxiety around the globe.
As a result, any further declines in the overall CPI are likely to moderate in the coming months. Still, there's a realistic probability that at some point in the next few months, the CPI will dip into negative territory on a 12-month basis and the word "deflation" will start appearing in headlines again.

The question that arises then is: Does this mean that the dreaded deflationary forces, which in the postwar era had visited only Japan among the major industrialized countries (for a protracted period starting in the '90s), have now reached the U.S. shore?
The answer is: not necessarily so, for two reasons:
1. A simple dip in the overall CPI for a few months into negative territory on a year-over-year basis is not tantamount to a full-fledged deflationary trend. For such a dynamic to emerge, it will take a more prolonged period of declining prices, which can only be achieved in the context of a lengthy and steadily deepening recession. This is not a totally unrealistic scenario, but it disregards the Fed's series of extraordinary measures (including Tuesday's decision to bring the overnight interbank rate down essentially to zero) and the massive domestic fiscal-stimulus program waiting in the wings. The combined effect of such unprecedented actions should help cushion any further downside risks beyond the first quarter of 2009.
2. A generally more reliable measure of inflation (although less popular in terms of broader public perceptions) is the core CPI, which, by excluding the two most volatile components (food and fuel) of the index, also tends to be dramatically more stable over time. True, the core index has also drifted lower since July but at a much more measured pace, 2% last month, down from 2.5%. Changes in the core index are very incremental on a month-to-month basis, so it is unlikely that it will slip into negative territory any time soon. In all likelihood, the economy will have already started showing signs of life by the time such a slow-moving downtrend brings the core CPI close to the feared zero mark.
It is exactly because of the less noisy nature of the core CPI that Fed officials tend to pay considerably more attention to that price measure--rather than the overall CPI--in addition to their favorite inflation indicator, the core PCE (Personal Consumption Expenditures) price index. Both of these measures are currently in the vicinity of 2% and unlikely to emanate any deflationary signals in the foreseeable future.
Naturally, the longer the recession drags on, the higher the risk that the current disinflationary trend will convert itself into a deflationary one. But the distance between the two is real and, at this point, the risk of the latter outcome -- beyond the phase of a simple arithmetic quirk for a short period--is indeed low.

Anthony Karydakis is a former chief U.S. economist with JP Morgan Asset Management and currently an Adjunct professor at New York University's Stern School of Business.

http://money.cnn.com/2008/12/18/news/economy/deflation_recession.fortune/