REFLATION, PART II

Today’s report on consumer price inflation (CPI) for February confirms yesterday’s news on wholesale prices for last month: deflation is on the run. For the moment, anyway.
That’s good news, but if it’s true, then monetary policy becomes increasingly tricky in the months ahead. We say if it’s true because it’s hard to make definitive conclusions on just a few months of data. At the moment, the case for arguing that deflation has been banished rests on January and February numbers. Deciding if that’s a trend with legs remains speculative, albeit less so than in the past several months. Only once it’s clear that the economy is past its worst point in the current downturn will it be obvious that deflation is no longer a threat. Where and when that point lies, alas, isn’t yet obvious, at least to this obsever.
Meanwhile, the Labor Department reports this morning that consumer prices rose 0.4% last month on a seasonally adjusted basis. That’s up from January’s 0.3% and both numbers stand in sharp contrast to the previous three months (Oct through Dec), when CPI dropped sharply.


Core inflation (excluding food and energy) was up 0.2%, as it was in January, suggesting that overall prices, as defined by the Federal Reserve, are more or less stable. For the year through February, core CPI advanced 1.8%, roughly in line with where the Fed would like to see it remain through time.
Does this mean the all-clear sign for deflation worries is past? Perhaps, but it’s still too soon to say. There was never any doubt that a determined central bank can engineer inflation. Indeed, that’s the natural order of economic behavior and many a central bank has unwittingly fostered higher inflation without necessarily trying. The fact that the Fed has been working over time to generate higher inflation as an antidote to elevated deflationary risks should surprise no one when the effort bears fruit.
One clue that the reflation efforts are more than noise comes by noting that CPI’s major subcatagories all posted higher prices last month save for food and beverages. The same was true for January, a month when food prices climbed as well. That’s a big and productive shift from 2008’s fourth quarter, when price declines were running hard. At the time, the fear was that the negative price momentum would build a head of steam and, left unchecked, would develop into sustained deflation.
As we write, there’s reason to think the Fed’s policy of nipping deflation in the bud is working. Is it time to pull the plug on the massive liquidity injections? No, not yet. There’s still a strong, negative headwind blowing in the economy, starting with the labor market. Until we learn more about how the current business cycle is unfolding, the case for keeping Fed funds just above zero is compelling. One metric to watch closely in the coming weeks is initial jobless claims, which is one of several critical components for estimating the current state of the business cycle, as we’ve discussed.
Meantime, Bernanke and company begin their two-day gab fest today at the Fed. As we write, the Fed funds futures market is expecting more of the same: leaving the Fed funds rate unchanged at just over zero. For the moment, that’s prudent, but it may not be so for much longer. When it’s clear that deflation is no longer a clear and present danger, it’ll be time to start raising interest rates to keep the inflationary medicine from bubbling over down the road. That’s not going to be easy in an economy that, even in the best of scenarios, is likely to be struggling for the foreseeable future.
In short, we may be nearing the end of the heightened risk for deflation. That suggests that a new era for monetary policy is coming, and it promises to be a difficult one, which is to say that the risk of error will be quite high. As inflationary pressures return, albeit slowly and tenuously, the central bank will have to navigate a fine line of keeping prices under control without creating excessive drag for economic growth. The previous run of monetary policy decisions look like child’s play by comparison.

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