The United States inflation data yesterday disappointed – expected to come out unchanged on the month, both the regular and the Core CPI declined by 0.1%. This may not look like much, but it is for the first time since the data is compiled that the Core CPI has declined for three consecutive times.
What does it mean? The road to deflation is open.
When Money Does not Move
Despite the Fed’s decisions since the health crisis started, inflation is unlikely to rise anytime soon. The problem comes not from the actions the Fed took – they are all inflationary. Instead, the money does not move, creating a vicious circle – banks do not have to whom to lend, and consumers see only falling prices. Hence, the buying decision is postponed.
Yesterday’s Fed economic projections revealed that it does not see inflation dropping below zero – but it does see low inflation for as far as the projections go.
Those fearing hyperinflation in the United States and a “contagion” in the rest of the world should know that under the current programs run by the Fed, hyperinflation is unlikely. At least, at this point.
The argument against hyperinflation comes from the fact that almost all Fed’s actions (e.g., quantitative easing, the largest easing tool Fed uses) is not increasing the money supply, but the monetary base.
Only if consumers end up lending to consumers and businesses, should we see a spike in inflation beyond the central bank’s target. The money supply did spike lately, but the money velocity declined at a faster pace. Without a rise in money velocity, extreme values for inflation are simply not possible.
However, when the money does not move, deflation threatens as inflation expectations begin to de-anchor. A deflationary environment is further fueled by lower energy prices – lower oil prices have a negative implication on long-term inflation expectations.
Although the Fed’s projections regarding inflation expectations appear well-anchored, let us not forget that a central bank targeting symmetrical inflation around the two percent level has a two-year horizon for building those expectations. However the month-to-month data is the one that shows how things go in the real economy and if those expectations are anchored – or need to be re-anchored.
So far, there is no palpable deflation risk in the United States. Yet, if the recent trend continues, more and more people will start pricing in that possibility.
If we judge by the precedent created by the Core CPI the other day, deflationary times may be closer than we like to think.