Prices Are Low, And That Could Be Bad

Two.

That’s the number the Federal Reserve Board’s policymakers wanted to see this year. Having an annual inflation rate of 2 percent would confirm that the U.S. economy is strengthening — workers are getting raises and companies are seeing enough customer demand to mark up prices.

But the 2-percent target turned out to be too high.

Tuesday’s reading of the consumer price index showed an advance of just 1.2 percent over the past year. In November, prices did not rise at all, and they actually declined a bit in October.

Yippee, right? Prices are low, so we should celebrate shouldn’t we?

Economists say low inflation does have some advantages, but it also can do damage.

The Upside Of Low Inflation

First, here’s what’s good about a low rate of inflation:

With low prices, consumers feel less pain at the gas pump and the grocery store. And the Fed has more room to keep holding down interest rates — making it cheaper for individuals to buy homes and cars. And it’s easier for the U.S. government to borrow money.

Low interest rates help make the stock market a more attractive place to put your money. And as anyone who lived through the 1970s could tell you, not fretting over double-digit inflation can be a relief.

Then There’s The Downside

But here’s what’s bad about low inflation.

For one thing, most workers would appreciate a pinch of inflation because they’d like a raise. Getting bigger paychecks can help pay off old bills. Consumers feel more confident when their car and mortgage payments are shrinking, relative to their earnings.

“If inflation is lower than expected, then debt financing is more burdensome than borrowers expected. Problems of debt overhang become that much worse for the economy,” Charles Evans, president of the Federal Reserve Bank of Chicago, said in a speech in October.

And low inflation can frustrate savers, too. Because the Fed has held down interest rates for years now, savers have gotten almost no return on money market funds and other safe investments. For many older Americans, the stock market still seems risky, but conservative investments bring no growth — a discouraging outcome after a lifetime of pinching pennies.

Shoppers’ reactions to low prices also can hurt the economy. When inflation is rising, consumers are more motivated to get to the store and buy what they need now, which stimulates growth. When prices aren’t rising, they may sit on their money and wait — hoping for lower sale prices.

How Low Inflation Hurts Companies

And think about the impact of inflation on manufacturers: When a company purchases raw materials at a certain price, it hopes to make a profit when that stuff gets turned into finished goods. But if prices are declining, then the company may find it has paid a high price for raw materials but can sell its finished product only for a lower price. A little inflation helps ensure that scenario doesn’t happen.

“Falling and low inflation can be very bad for an economy,” Fed Chairman Ben Bernanke said in July.

Inflation Can Give Consumers A Lift

Oh, and one other thing: Inflation can serve as a mood elevator. For example, most Americans feel more optimistic when they are seeing home values gently rising. An appreciating asset makes you feel as if you are getting wealthier, even if it’s mostly an illusion.

After an awful event like the Great Recession, “a sustained burst of moderate inflation is not something to worry about,” Harvard economist Kenneth Rogoff wrote. “It should be embraced.”

But such a burst has not appeared. Time and again, the inflation rate has come in well below expectations.

“Inflation continues to surprise to the downside,” Federal Reserve Bank of St. Louis President James Bullard said earlier this month at a meeting of the CFA Society of St. Louis.

No Signs Of A Resurgence

Most economists believe inflation will remain low next year. For example, IHS Global Insight, a forecasting firm, sees a 1.4-percent inflation rate in 2014.

Fed policymakers will weigh the latest inflation data as they meet Wednesday. At 2 p.m., they will reveal their thinking. If they conclude inflation is too low, they may hold off on their long-planned “tapering” down of a bond-buying campaign. In other words, they would delay making the kinds of moves that could allow interest rates to rise.

So why has the inflation rate turned out to be so much lower than expected?

The suppression of wage and price pressures has been tied to several factors. For one, energy prices have eased this year as U.S. companies have produced more oil and gas and relations between the West and Iran seem to have improved.

For another, with the unemployment rate at 7 percent, most companies don’t need to raise wages to attract workers. And they aren’t seeing as much customer demand as before the recession.

“Demand is still soft in most parts of the economy and businesses are wary about raising prices,” wrote Stuart Hoffman, chief economist at PNC Financial Services. “At the same time, wage growth is weak and input costs are not increasing, while profit margins are solid, giving firms the ability to hold the line on prices.”

The Low-Inflation Mystery

But while those factors matter, it’s hard to fully explain exactly why inflation is so low. Yes, the labor market is weak, and energy prices have eased. But with the Fed taking one step after another to stimulate growth, shouldn’t there be a lot more cash sloshing around, pushing up prices?

Bullard in effect said he’s scratching his head: “There is no widely accepted reason why inflation is running as low as it is in the face of extraordinarily accommodative policy from the Fed,” he said.

Some economists fear that inflation really is lurking; it’s just smoldering out of sight. Sooner or later, the danger will burst into the open and set the economy ablaze.

John Makin, an economist with the American Enterprise Institute, a conservative research group, has said the Fed’s efforts to stimulate growth are setting up inflationary expectations. In the long run, the group said, those expectations could lead to “an eventual period of rapidly rising inflation and interest rates like what characterized the late 1970s and early 1980s.”