Deflation Diverted or Delayed?

In July, the Producer Price Index (PPI) increased by 0.2% from June and was up 4.2% from a year ago. That increase was in line with consensus expectations. The increase comes on the heels of three straight declines and declines in four of the last five months. In June, the headline PPI fell by 0.5% and in May it was down by 0.3%. Still the PPI was running on the hot side last winter so the year-over-year change is a relatively hot 4.2%.

Stripping out the volatile food and energy components to get the Core PPI, prices rose 0.3%, which was higher than the 0.1% that was expected. On a year-over-year basis they are still very tame at just 1.5%. Finished food prices rose 0.7% at the wholesale level in July reversing three straight declines. Energy prices, on the other hand, declined by 0.9% making July the fourth straight month of declines.

Looking further up the production chain, things are a bit murky. Prices for intermediate goods (think wheat, flour, bread to keep the stages of production straight) fell by 0.4% on a headline basis after a decline of 0.9% in June but are up 6.4% from a year ago. Core intermediate goods prices fell 0.4%, matching the decline in June and on top of a 0.3% drop in May. Crude goods, which are essentially commodities, saw prices increase by 2.7% in July, reversing a 2.4% decline in June and a 2.8% drop in May. Still, over the course of the last year, they are up 20.5%.

At the crude level the increase was all in the volatile food and energy segments. Core crude prices fell for the third month in a row, dropping 1.4%. Crude energy prices rose 4.5% in July on top of a 1.7% increase in June, but that came after a 5.1% drop in May. Added in part by the drought in Russia, and the floods in Pakistan, crude food prices rose by 3.3% in July, reversing declines of 5.3% in June and 0.6% in May.

I actually see the higher-than-expected core PPI as being good news, since it means that the country is less likely to be falling into a deflationary trap. Deflation still appears to be a greater threat than runaway inflation, but this report indicates that the threat is less than it was last month. With lots of slack still in the economy (although starting to diminish as evidenced by this morning’s report on capacity utilization) it will be hard for producers to pass through commodity price increase to the consumer level.

I’m still not sure if deflation has been defeated, or just delayed. People will just sit on their wallets if they think they can get a cheaper price for goods in the near future. As that happens, demand slows down and with it the overall economy. Deflation means not just lower prices, but ultimately, lower wages as well. Deflation also means that real interest rates rise, since nominal interest rates can not fall below 0% (just stuffing dead presidents into a jar and burying it in the back yard would be better in that case). That makes life very tough for anyone who is in debt. It also greatly raises the likelihood that debtors will default, so it’s not great for creditors either. Thus, 3 or 4% deflation is FAR more damaging to the economy than 3 or 4% inflation. Policy makers have to avoid it at all costs.

That might put a bit of pressure on margins, although businesses have so far been able to cut costs by more than enough to compensate, and by and large net margins have improved significantly over the last year. The turnaround in crude food prices mean good news down on the farm, and for companies who have their fortunes tied to agriculture. This might be part of BHP Billiton’s (BHP) reason for making its hostile bid for Potash Corp. (POT) today. It is also probably a good omen for firms like Deere (DE) and the seed companies Monsanto (MON) and DuPont (DD).

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