Inflation vs. gold vs. deflation

US core consumer price inflation hits its lowest point in 49 years, so which is the major worry - inflation or deflation?

JOHANNESBURG - 

US core consumer price inflation has fallen to under 1%, the lowest annual rate recorded in 49 years, posing a dilemma of sorts for scaremongers warning of hyperinflation, blamed on "incessant printing of money" by central banks. Gold bullion, say the gold bugs, is the answer to fiat money, and the best hedge against rampant inflation.

It seems that if anything, disinflation could be the big issue for investors to fret about. The outcome over which emerges is crucial to practically all investment decisions. Economists generally agree that while a low inflation rate is generally acceptable, disinflation can be positively dangerous. The phenomenon demoralizes everyone, from central bankers to workers, who worry about whether they will soon have no pay at all.

The level of inflation determines central bank decisions over the direction of interest rates, impacting bond and debt markets, spilling over into equity markets, and so on. During inflationary upcycles, hard assets such as property (given a fair to good address) and commodities find favour; in a deflationary environment, practically everything and everyone suffers.

Mohamed El-Erian of PIMCO, the world's biggest bond fund, recently reported back from a forum where he noted that "some argued that given the output gap in industrial countries, it would be very difficult to generate inflationary pressures for the next three years. Indeed, the risks were tilted toward further disinflation.

"A larger group warned that while the output gap framework was applicable to the next 12 months, the period beyond that could witness the impact of increasing monetisation of debt, gradually rising inflation rates and a worsening of inflationary expectations".

El-Erian anticipates that the potential evolution, from disinflation to inflation, "will likely proceed at different speeds in different parts of the globe. It is already well in train in emerging economies and will remain so. Over the medium term, the US will be next, with Europe and, even more, Japan lagging".

In the US, experts at the Bank Credit Analyst say that "wide slack exists in key parts of the economy, which will keep a lid on consumer price inflation for the foreseeable future.

Of the three major components of core CPI, shelter is already in deflationary territory, while goods price inflation has finally rolled over decisively. Services sector inflation remains near the bottom end of its multi-year range. We expect that core inflation will continue to head lower.

"Although economic activity has picked up in recent quarters and a sustainable recovery is underway, the output gap remains wide and there are virtually no signs of pricing pressure at the retail level".

Major retailers such as Wal-Mart have recently announced further price slashing, citing customers' precarious financial positions. BCA Research argues that while "it is encouraging that employment growth has turned positive, the unemployment rate is still very high, suggesting that consumers will remain very price-conscious for some time. This environment underscores that there will be considerable disinflationary pressure and outright deflation in the core CPI index should not be ruled out".

While the outlook for inflation remains vexed, its very definition continues to evolve. In many countries, consumers believe that official statistics believe that statistical releases understate the real rate of inflation. In Japan, by contrast, deflation, real or imagined, has plagued the country for decades, rather than years.

Core inflation, as currently seen in the US, is a measure of inflation which excludes certain items that face volatile price movements, notably food and energy.

The more precise measure of core inflation preferred for use by the Federal Reserve, the US central bank, is the core personal consumption expenditures price index (PCE).

The US's Bureau of Labor Statistics  prepares the traditional CPI, the Consumer Price Index, for all urban consumers (CPI-U); the US's Bureau of Economic Analysis then prepares the Personal Consumption Expenditures (PCE) chain-type price index. Both indexes measure the prices paid by consumers for goods and services, but are based on different underlying concepts, with different constructions, and tend to vary over time.

Since February 2000, the Federal Reserve Board's semiannual monetary policy reports to the US Congress have described the Board's outlook for inflation in terms of the PCE.

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