After months of inflation coming in way above the Fed’s target, the latest releases show a different trend. US monthly CPI figures for December showed a drop in prices, largely aided by energy prices. Yesterday, producer prices came in much more negative than expected.
If inflation is bad, then the opposite would be good, right? Not so much. The opposite of inflation is deflation, and it can be just as bad for the economy as inflation. Particularly in the case of the US, where the Fed has never had to deal with runaway inflation. High inflation, yes; but hyperinflation like experienced in Europe in the last century, for example, has not happened. What the Fed did have to deal with up until the US left the gold standard, were bouts of deflation. And, as such, the Fed tends to be more worried about deflation than inflation.
The warning signs
More immediately for traders, however, deflation is an important warning sign. Increasing economic activity typically translates into growing prices; and the reverse, slowing economic activity typically translates into deflation. Looking at yesterday’s data, the surprise deflationary PPI came along with a surprise drop in retail sales and industrial production. The data was expected to be negative, but it was a lot more negative than expected.
A similar vein is expected in the coming data to be released later today and tomorrow relating to the largest component of the American economy: Housing. Home prices have been on the backfoot as rising interest rates have made buying houses much more expensive. But, over the last few weeks, interest rates have been coming down, including the average mortgage rate.
What are the projections
Despite the lower costs to buy, housing starts are expected to continue to fall, forecast at 1.36M compared to 1.43M in November. Typically in the winter, homes sell slower, but the expected slowdown is much faster than what is typical of the season. Existing home sales are also expected to continue its descent to 3.96M compared to 4.09M in November.
In the wake of the latest data, the dollar slid compared to other pairs as the US benchmark bond rates slid, hitting the lowest level since last September. The greenback was at its worst level since May of last year. Which brings us back to the potential Fed reaction.
Which way are we going?
This shift in price trends is happening in the middle of a market debate over whether the Fed will raise rates and keep them high, or there will be a pivot and the Fed will cut rates. Traditionally, the Fed is much quicker to cut rates to head off potential deflation than it is to raise rates to counter inflation. In the end, the Fed does want there to be some (controlled) inflation.
For now, the deflation has shown up in the headline CPI figure and PPI, which aren’t the key metrics used by the Fed to determine rates. Some volatility in the headline inflation number is understandable, particularly when the Fed is trying to lower inflation. But if this is the first sign that negative inflation numbers will become the norm, then it could increase the chances of a Fed rate cut in the near future.