Consumer Prices Fall 0.3%, Raising Deflation Concerns

Consumer prices fell last month for the first time in almost two years, the Labor Department reported Friday, suggesting that the U.S. economy may be closer to deflation, or a broad decline in prices, than most people had thought.

Although the bulk of the 0.3% slide in the consumer price index was because of a postwar drop in the cost of oil and gasoline, the price measures that exclude volatile food and energy prices remained stuck at zero for a second month in a row. The last sustained period of zero price growth in so-called core inflation was the mid-1960s.

If current trends continue, analysts said, April would mark the end of a 30-year period in which consumers and policymakers worried about inflation, and the opening of an era in which deflation would flip familiar rules about work, spending and investment on their heads.

“It’s a watershed development to see core inflation continuing to moderate in the way it is,” said William Sullivan, a senior economist with brokerage Morgan Stanley in New York.

The most immediate effect of the new price numbers will be to boost pressure on the Federal Reserve to cut already extraordinarily low interest rates.

Fed policymakers warned this month that they were concerned about an “unwelcome substantial fall in inflation.” That surprised the financial world because it appeared to represent an about-face for an institution that has spent most of the last generation trying to stamp out inflation.

Analysts predicted the central bank would cut its signal-sending federal funds rate, the interest banks charge each other for short-term loans, to 0.75% from the current four-decade low of 1.25% at its June 24 meeting.

“The Fed is in the ironic position of having spent years working to achieve price stability and now deciding they don’t want quite so much of it,” said Stephen G. Cecchetti, a former Fed economist now at Ohio State University in Columbus.

Analysts said further Fed cuts could spark a new round of mortgage refinancing and home and car purchases. But they warned that any buying spree may not be very powerful because consumers have incurred substantial debt loads and may be nervous about job security.

Investors reacted to the consumer price figures Friday by driving up bond prices and pushing stock prices modestly lower.

The yield, or market interest rate, on the benchmark 10-year U.S. Treasury note skidded to a 45-year low of 3.42%. The Dow Jones industrial average ended the day down 0.4%.

Economists had expected consumer prices to fall in April if only because of declining energy prices in the wake of the war in Iraq. In fact, energy prices took a dive, with gasoline prices tumbling 8.3% and fuel oil prices plunging 14.6%, their biggest decline since 1990.

But analysts were caught off guard by medical care price trends. Medical costs, rising at near double-digit rates only last year, have slowed sharply.

For example, hospital services, which posted the biggest jump of any in the price index, were up 0.2% from their March levels and 7.3% from a year earlier. But that was a deceleration from just a few months ago, when hospital services inflation was running at almost 10%.

April’s 0.3% decline in the price index followed a 0.3% increase in March. Core inflation was up 1.5% in the last 12 months, the smallest annual increase since 1966.

Deflation warnings have left many Americans confused, in part because lower prices seem to be a good, not bad, thing.

In fact, the most authoritative source of the warnings, the Fed, may be more worried about declining prices than consumers. That’s because deflation can seriously undermine the central bank’s ability to manage the economy, especially in times of slow growth and low interest rates such as the present.

“Low prices are a good thing for consumers unless they start falling in a rapid, destabilizing fashion,” said Gregory D. Hess, a former Fed economist who now teaches at Claremont McKenna College. “They may not be as good for the Fed.”

The problem for the Fed is that its chief tool for sparking growth is interest rate cuts. In periods of inflation, it can effectively cut rates below zero because with prices rising at, say, 3% a year, the value of a dollar used to repay a loan is falling by the same amount. So if the Fed slashes the nominal interest rate to zero, a borrower’s after-inflation rate is actually minus 3%.

By contrast, when prices are declining at 3%, the value of a dollar used to repay a loan is rising by the same amount. In this case, if the Fed cuts the nominal interest rate to zero the real borrowing rate remains stuck at 3%.

Analysts said the central bank is so concerned that if prices keep sliding, it is likely to reverse the course that it has been on for a generation -- and try to cause a little inflation.

Fed policymakers “will redouble their efforts to ensure inflation rises back over 2% or possibly even to 3%,” predicted former Fed staffer Cecchetti.

If deflation persists, it might be consumers who change course. People who are used to spending aggressively, in part out of concern that prices could rise, might find themselves instead waiting for lower prices.

At the same time, assumptions about wages -- the idea that workers sooner or later would get raises -- could disappear if employers can argue that real wages are increasing automatically as prices fall.