Friday, May 16, 2003

DEFLATION?

Deflation's Nasty Curse (SafeMoneyReport)

The Federal Reserve danced around the "D" word in its policy statement last week, expressing fear of "an unwelcome substantial fall in inflation." But today's consumer price index (CPI) report made it clear: Deflation is here, and that spells trouble for the economy and the stock market. Excluding volatile food and energy costs, CPI rose only 1.5% in the past year, the smallest 12-month increase since 1966. Energy prices dropped 4.6% in April, the biggest decline since November 2001. Clothing prices fell 0.6%, and personal computer prices plunged 1.6% in April. With unemployment at an eight-year high of 6%, people fear losing their jobs and are thus reluctant to spend. So businesses see that they have to cut prices to entice more buyers. But the lower prices mean lower profits. And lower profits mean lower wages, which can ultimately force consumers to the sidelines. In other words, deflation presents a vicious cycle. The result is economic contraction and a falling stock market. Look out below!

Fears grow that US economy faces deflation, Financial Times, May 16 2003, " Fears of deflation in the US rose on Friday as stock prices fell and government bond yields dipped to 45-year lows after a key measure of inflation dropped to its lowest level in 37 years ... In the US the yield on 10-year and 30-year US Treasury bonds fell to 3.49 per cent and 4.45 per cent in early trading. Longer-dated US government bonds have rallied sharply this week, with investors convinced that inflation will remain subdued, having less of an impact on the value of long-term assets. The Labour Department reported that the 12-month rise in its core consumer price index fell to 1.5 per cent in April, its slowest 12-month rate of increase since January 1966. Strategists said the subsequent fall in bond yields could, however, be positive for the economy. "This is what the Federal Reserve wants," said Dominic Konstam, head of interest rates products research at Credit Suisse First Boston. Falling yields mean falling borrowing costs, which make it easier for businesses to borrow and homeowners to refinance mortgages and get extra cash - factors that have helped keep the economy afloat. But the sharp slowdown in inflation has inflamed talk of Japanese-style deflation ... Most economists in the US have dismissed deflationary risks as marginal. But the Fed said recently that odds of an "unwelcome substantial" slowdown in inflation were now stronger than that of a rebound. "We continue to believe that inflationary pressures are building," said Brian Wesbury, an economist with Chicago-based, bond-trading firm Griffith Kubik, Stepehens and Thomson, but "it is getting harder and harder to argue against the deflation story".

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