European chill puts inflation on ice

By Emily Kaiser

WASHINGTON (BestGrowthStock) – Europe’s travails have put a chill on inflation, and it may be many months before it warms up again.

Commodity prices, particularly oil, fell sharply in May and that is likely to translate into negative readings on three U.S. inflation gauges coming this week.

Assuming the global recovery remains on track, this bout of disinflation will probably dissipate by early next year.

Inflation tends to lag a good 1-1/2 years behind economic growth, said UniCredit U.S. economist Harm Bandholz, so last summer’s recovery should show up some time around next January.

If the recovery unravels, however, falling prices could become a serious problem.

Europe’s connection to U.S. May inflation trends is two-fold.

First, investors fearful of euro zone debt troubles poured money into U.S. dollars, seen as a safe haven during troubled times. Since commodities are typically priced in dollars, the strengthening currency drove down prices for oil and other globally traded goods.

Second, many economists have marked down global growth forecasts because of concerns that debt-weary Europe will slam on the fiscal brakes. Slower growth means weaker demand, and that is showing up most clearly in the price of crude oil, which dropped 16 percent in May.

Cheaper oil is the primary reason why economists think Tuesday’s report on U.S. import prices will show a 1.3 percent decline. Figures for U.S. producer and consumer prices, coming Wednesday and Thursday, are also expected to decline.

Euro zone May inflation data also comes on Wednesday, and is expected to show month-over-month prices barely budged.

GREAT EXPECTATIONS

For the U.S. Federal Reserve and the European Central Bank, falling inflation means no pressure to raise interest rates from record lows. The ECB kept its rate unchanged at 1.0 percent last week, and the Fed is widely expected to hold short term rates steady near zero at its next policy-setting meeting later this month.

Judging from forecasts released in May, the Fed’s expectation is that inflation will remain at the low end or below its comfort zone through 2012.

That prediction assumes the U.S. economy keeps growing at better than a 3.0 percent clip. If Europe’s debt problems mushroom into something severe enough to derail the recovery, a prospect Fed officials see as remote, benign inflation could give way to damaging deflation.

When consumers believe they can get a better deal tomorrow, they put off purchases, setting off a hard-to-break cycle of recession and deflation.

So far, there is no evidence that U.S. consumers are in that mind-set. The Fed keeps its eye on inflation expectations, and Friday’s Thomson Reuters/University of Michigan survey showed consumers were expecting a relatively lofty 2.8 percent inflation over a five-year horizon.

WHERE TO?

Beyond 2010, the likely path of inflation is a subject of fierce debate.

Some think central bankers planted the seeds of runaway prices by printing money to prop up the economy during the latest recession. While banks are hoarding that cash now, they won’t stay timid forever and once that money is unleashed inflation could quickly get out of hand.

However, a key ingredient of inflation is competition over scarce resources — particularly labor — and there is little reason to believe supplies will tighten up any time soon.

Bank of America Merrill Lynch economist Neil Dutta thinks U.S. unemployment will average 9.5 percent this year and fall only modestly to 8.7 percent next year, keeping the Fed on hold until August 2011.

“Slack will be abundant for several years,” he said.

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European chill puts inflation on ice