Bank of the West U.S. Outlook Report for February 20, 2015

U.S. Outlook Report: Deflation Arrives in the United States

We have been advertising it for a while now, but the January price data are finally coming in and the U.S. price deflation is as dramatic as I thought. Producer prices for January dropped 0.8%, twice as fast as the consensus of economists expected, and the year-on-year decline was 3.3%.  Outside of the Great Recession of 2009, there was only one time producer prices dropped this much in twelve months in the post-war period and that was 1949.

Looking at producer prices by the stage of production, it is clear that commodity or crude-good prices are driving the declines.  Price of crude-good producer prices dropped an eye-popping 18.3 percent from a year ago in January.

Relief may soon arrive at the grocery store, too. The producer price inflation of finished consumer foods slipped to 3.9 percent from over 5.0 percent last month, and deflation is now occurring in intermediate and crude food stuffs as well, suggesting more downward pressure on consumer food prices in the months ahead.

Away from the volatile food and energy sectors, producer prices appear much more stable. Even so, core inflation appears to be moving further away from the Federal Reserve’s targeted goals. Seasonal adjusted core producer price inflation has slipped a half a percent in two months to 1.5 percent from a year ago.

Still, if crude oil prices can stabilize near $50 per barrel, the current bout of U.S. deflation could dissipate rather quickly. That doesn’t mean 2.0 percent plus consumer inflation is right around the corner either.  The strong dollar will continue to exert downward pressure on import prices that are likely to offset for a time any upward pressure on consumer prices from rising wages.  Import prices dropped 2.8 percent last month and are 11.1 percent lower than a year ago.

We get another dose of price readings next week, this time from the consumer price index. We expect a 0.6 percent decline for January that will push the year-on-year consumer price index into deflation territory for the first time since 2009. The only other periods of U.S. consumer price deflation occurred all the way back in the mid-1950s!

This creates a near-term communication challenge for the FOMC to justify liftoff and the normalization of interest rates. How do you explain to Congress and the American people that you are defending your inflation mandate on the downside when you have missed your inflation target for two years and actual inflation is still moving away from your goals?

While consumer inflation should start turning-the corner by the June FOMC meeting, for now the Fed is content to plan for liftoff and remain in wait and see mode on inflation.

To learn more, check out this week’s US Outlook Report.