Deflation concerns grow as consumer prices shrink

[January 17, 2009]  WASHINGTON (AP) -- Consumer prices tumbled yet again in December, and inflation last year logged its smallest advance since the early 1950s, fanning new fears that the country may face a dangerous bout of deflation.

Worries about out-of-control price increases - which had gripped the Federal Reserve and the country just seven months ago are now a distant memory. Some wonder in hindsight: Should the Fed have kept cutting interest rates all last year to help the recession-shocked country, rather than stopping in the summer and early fall out of concerns that lower rates would spur inflation?

The Labor Department's latest inflation report, released Friday, showed consumer prices dropped 0.7 percent in December, marking the third straight month prices fell.

For all of 2008, prices inched up 0.1 percent, the smallest increase since 1954. Although prices spiked during some summer months - as oil hit record highs and food prices marched upward- the inflation threat of 2008 ended up fizzling.

And that's a dose of welcome news to the strained pocketbooks of American consumers, who have cut back sharply on their spending under the negative forces of vanishing jobs, tanking home values, dwindling investment portfolios and a recession, now in its second year.

Average weekly earnings, after adjusting for inflation, rose 2.9 percent last year, a big improvement from 2007 when earnings fell 1 percent, the government report showed.

Looking ahead, economists expect consumer prices will continue to fall over the next several months. For all of 2009, some economists said it's possible prices will be flat or dip.

Falling prices sound like a gift at first - at least to consumers. But a widespread and prolonged decline can wreak more havoc on the economy, dragging down Americans' wages, and clobbering already-stricken home and stock prices. Dropping prices already are hurting businesses' profits, forcing them to slice capital investment and lay off workers.

More pain on that front came Friday as employers announced thousands more job cuts.

Circuit City Stores Inc. is closing all its U.S. stores and cutting 30,000 jobs. Rental car company Hertz Global Holdings Inc. is eliminating 4,000 jobs worldwide and Insurer WellPoint Inc. is cutting about 1,500 jobs.

"I think deflation is setting in," said Mark Zandi, chief economist at Moody's Economy.com. "Given the sliding economy, businesses are under extreme pressure to lower prices to maintain sales."

Stripping out volatile food and energy prices, "core" inflation was flat in December. For 2008, it rose just 1.8 percent, the smallest increase since 2003.

Although chances remain slim that the country will get caught in such a downward price spiral, the mere whiff of deflation is a concern for economists and some at the Fed. "Some members saw significant risks that inflation could decline and persist for a time at uncomfortably low levels," recently released documents of the Fed's closed-door meeting in December revealed.

At that time, the Fed took the unprecedented step of slashing its key interest rate to between zero and 0.25 percent, an all-time low. It signaled rates would stay at those levels for some time to help revive the economy. Many economists predict the Fed will keep rates at record lows at its next meeting Jan. 27-28 and probably through the rest of this year. Doing so also would help fend off any deflationary risk, economists said.

America's last serious case of deflation was during the Great Depression in the 1930s. Japan was gripped with a period of deflation during the 1990s, and it took a decade for that country to overcome those problems.

The 180-degree flip from inflation to deflation worries in a matter of months shows how quickly economic dangers can shift during these tumultuous times.

And that underscores the challenges faced by Fed Chairman Ben Bernanke and his colleagues in trying to turn around the economy, which has been walloped by the worst financial, credit and housing crises since the 1930s.

Consumer prices spiked 1.1 percent in June, the second-fastest pace in a quarter-century. Inflation worries ran so high that the Fed halted its rate-cutting campaign later that month. The Fed stayed on the sidelines until Oct. 8, when it joined other major central banks and slashed rates in a global effort to limit damage from a financial crisis that had rapidly intensified. The Fed then continued to ratchet down rates through the rest of last year, including its historic action in December. The sharp and quick deterioration in the U.S. and global economies significantly reduced inflation threats.

"I don't think the Fed could have predicted that the economy would fall off a cliff and take inflation down with it," said Richard Yamarone, economist at Argus Research.

Even if the Fed kept slicing rates through the summer - rather than taking a break - the lower rates probably wouldn't have done much to revive the economy, analysts said. That's because the potency of the Fed's rate cuts have been blunted by the very credit crisis it is battling.

Banks haven't ramping up lending to customers. And worried consumers have been cutting back on spending - despite low financing rates. The Fed, which has acknowledged as much, said that's why a host of radical programs by it and the Treasury Department are so important in trying to bust through the stubborn credit clog.

"The Fed is applying its muscle where it can to reduce stresses in the credit market," said Robert Dye, economist at PNC Financial Services Group.

On the inflation front, energy prices fell 21.3 percent last year as the global economic slowdown sapped demand. Food prices, however, went up 5.9 percent.

Kellogg Co., the world's leading maker of breakfast cereals, has been increasing the price of its products, like Frosted Flakes, and competitors with less market share have followed suit, UBS analyst David Palmer. The "substantial pricing action" Kellogg took gives it wiggle room to promote, and play with pricing, as input costs come down, he wrote in a note to clients Friday.

Food companies that have raised prices are better positioned this year. If those companies have to lower prices this year to match price cuts by competitors, it won't hurt their profit margins as much, analysts said.

Kellogg's most recent pricing action was announced in the fall. Starting next week, there will be low-to-mid single digit percentage price increases on Pop-Tarts and the bulk of the Battle Creek, Mich.-based company's cereal brands, but not All-Bran or Special K.

For these difficult economic times, both companies and Washington policymakers need to be nimble and creative.

"There is no playbook for this crisis," Dye said.

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AP Economics Writer Martin Crutsinger in Washington and AP Food Industry Writer Emily Fredrix in Milwaukee, Wis., contributed to this report.

[Associated Press; By JEANNINE AVERSA]

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