Last Friday, the U.S. Labor Department reported that the consumer price index (CPI) rose 0.2% in January and climbed by 2.6% over the past 12 months. But after stripping out volatile food and energy prices, prices actually fell by 0.1% in January, marking the first time since 1982 that "core CPI" has declined.
While the absence of any signs that runaway inflation is materializing initially soothed markets, the report also signaled that another potentially tricky economic drag, deflation, is a very real concern.
Investors have been bracing for a major uptick in prices in the wake of unprecedented liquidity injections to stimulate a stalling economy, so to many the news of sagging prices was a relief, especially in light of recent actions from the central bank. The recent Fed increase in the rate charged on emergency loans to banks had seemingly paved the way for a hike in other short-term interest rates. But interest rate increases are usually spurred by rising inflation, so the tame CPI numbers increase the likelihood that rates will remain near record lows, at least for the time being. "There is just no inflation pressure in the U.S., so our focus has to be on growth and jobs," said William Dudley, president of the Federal Reserve Bank of New York.
But analysts note that investors should be careful what they wish for, as extended periods of deflation can cause major problems as well. When prices are continually falling, consumers tend to delay major purchases in hopes of securing desired goods later at a lower cost. And because wages are generally more sticky than most CPI components, labor-intensive businesses can see their profit margins shrink as a decline in revenue is not met with a commensurate pullback in production costs.