Forget Inflation – Fed Fears a New Deflation Threat

Last week’s economic fears were exacerbated by the release of the latest Federal Open Market Committee (FOMC) minutes, in which it became very clear that the FOMC members were divided over the economic slowdown and the deflation risks to the U.S. economy. Officially, the Fed lowered its 2010 GDP forecast to a range of 3.0% to 3.5%, down from its previous forecast of 3.2% to 3.7%, but the FOMC deflation debate was the most disturbing news, due to the release of America’s two major price indexes last week.

The Labor Department announced on Thursday and Friday that June’s Producer Price Index (PPI) and Consumer Price Index (CPI) fell 0.5% and 0.1%, respectively. Although lower food and energy prices are largely responsible, the CPI has now fallen three months in a row, making some FOMC members nervous.

However, the June core rates (excluding food and energy) actually rose 0.2% (for the CPI) and declined by just 0.1% (for the PPI). In addition, during the first half of July, the U.S. dollar has been on a slippery slope, which tends to increase food and energy prices. (July prices won’t be reported until mid-August.)

Another reason the U.S. dollar was on a slippery slope last week is that the U.S. economy seems to be slowing down and even turning negative in some key indicators. On Tuesday, the Commerce Department announced that retail sales declined 0.5% in June, worse than the 0.1% decline economists anticipated. Inventories also contracted by 1.5%, due to the fact that businesses are cautious. Contracting inventories can dramatically reduce economists’ GDP estimates, which is bad news for second-quarter GDP growth.

On Thursday the Fed announced that U.S. industrial output rose only 0.1% in June, and this rise was due largely to the recent heat wave, yielding a 2.7% rise in utility output. But manufacturing declined 0.4%.

On Friday, we got the week’s most shocking news when the University of Michigan/Reuters consumer sentiment index for July fell nearly 10 points, from 76.0 to 66.5, well below economists’ consensus estimate of 74, reaching its lowest level since August. Also, the “expectations index” dropped to 60.6 in July from 69.8 in June, so future consumer spending, which represents 70% of GDP, remains uncertain.

Despite all the gloom and doom, however, the 55 economists surveyed by The Wall Street Journal are more optimistic about the direction of the economy than the general public: 64% of these 55 economists said that the economy will get better over the next year, while only 9% said it would get worse.

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