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As Consumer Price Index falls for third month, deflation risk emerges

The Consumer Price Index declined 0.1 percent last month, following a 0.2 percent fall in May and a 0.1 percent drop in April. This suggests that the Fed hasn't completely removed deflation risks.

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Deflation remains a threat for the struggling US economy, despite massive efforts by the Federal Reserve over the past two years to mitigate that risk.

That's the message coming from the Consumer Price Index (CPI), which posted a decline in June for the third straight month, according to a Labor Department report released Friday.

The price index declined 0.1 percent last month, following a 0.2 percent fall in May and a 0.1 percent drop in April.

The index, designed as an overall gauge of price pressures from the grocery store to college tuition, is still higher than it was a year ago. But the recent trend suggests that the Fed hasn't completely removed deflation risks.

The news comes as other indicators also point to weakness in the economy's nascent recovery. An index of consumer sentiment, released by Reuters and the University of Michigan Friday, took a 9.5-point dive in a preliminary July reading to 66.5, the lowest reading for that index in nearly a year.

Although consumers don't generally complain if prices at the supermarket or gas pump go down, deflation can be a serious problem if it the pattern becomes persistent. In that case, it's just about the worst enemy of economic recovery. It can mean that consumers and businesses delay key purchases (expecting prices to fall further), wages face downward pressure, and debts become harder to repay.

"Once again the rate of inflation is getting too close to deflationary territory, something the Federal Reserve is not thrilled about after doing so much to prevent deflation," economists Eugenio Alemán and Sam Bullard of Wells Fargo Securities wrote in an analysis of the new numbers.

So far, the Fed has been successful in preventing a destabilizing deflationary spiral. Despite high unemployment and declines in housing prices in much of the United States, the Consumer Price Index stands at a higher place today than it did when the recession began at the end of 2007. The index is up 2.6 percent during that time.

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The recent price-index declines have been influenced heavily by energy costs, which have fallen on worries about the pace of global recovery.

But a so-called core index of prices, excluding food and energy, actually rose modestly in June. This core index is up 1 percent in the past year. That's not deflation, but the number hasn't been that low since 1963.

The records of a June Federal Reserve meeting, released this week, show that the central bank is carefully monitoring the pace of recovery and the trends in consumer prices. So far, most Fed policymakers expect they won't need to impart new monetary stimulus, beyond what's already in place. (The Fed's short-term lending rate for banks stands at a historic low of zero percent.)

Key indicators for the Fed to watch will include that core inflation rate and hourly wage rates in the private sector.

"Nominal wages appeared to be rising only slowly," the Fed concluded, according to the minutes released. But only a few Fed policymakers raised deflation as a concern in the meeting.

Some economists say the threat is considerable, unless the US job market improves substantially.

But Michael Darda, chief economist at the Connecticut investment firm MKM Partners, said in a note to clients Friday that the threats of either deflation or runaway inflation appear fairly well contained for now. "The relapse into recession and deflation in the late 1930s in the U.S. and the Lost Decade period in Japan were largely the result of policy errors," he says, "that are not likely to be duplicated by the Fed."

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