Producer prices drop revives prospects of deflation

WASHINGTON -- The threat of national deflation, an economically dangerous long-term slide in prices, rose anew Friday with a second monthly decline in wholesale costs.

The Federal Reserve is expected to shave interest rates this month to guard against possibly worse problems.

The Labor Department reported Friday that its Producer Price Index, which measures prices before they reach consumers, fell 0.3 percent in May from April. That decline followed a record 1.9 percent plunge in wholesale prices registered from March to April.

A big part of the decline in wholesale prices for both months came from retreating energy prices, which had been stoked in previous months on war tensions. Prices for some other goods, including clothing and trucks, also went down.

"There are many flavors of deflation," said Mark Zandi, chief economist at Economy.com. "A mild case can hurt businesses but usually isn't a problem for consumers. But in a severe case, ... everyone is going to get nailed."

The back-to-back declines in wholesale prices come in the aftermath of recent warnings by Fed chairman Alan Greenspan and his colleagues about the possibility of the country facing deflation, which is a widespread and destabilizing fall in prices.

Although Fed policy-makers say the chance of that happening is remote, the Fed still must be alert for deflation because of its potential to wreck the economy, they said. While the country experienced limited bouts of falling prices at the end of the 1940s and in the mid-1950s, the United States' last serious case of deflation was during the Great Depression.

In a bad case of deflation, prices generally fall for goods, services, stocks and real estate, economists said. Businesses, watching incomes and profits shrivel, lay off workers and cut salaries of those who retain their jobs. Individuals and businesses find it harder to pay off debt. Bankruptcies rise.

"The issue we're concerned about is not deflation in the sense of falling prices per se, but the issue of what I would call corrosive deflation," Greenspan said last week.

On Wall Street, stocks fell. The Dow Jones industrial average lost 79.43 points to close at 9,117.12.

Friday's PPI report reinforced economists' belief that the Fed will cut short-term interest rates, now at a 41-year low of 1.25 percent, by at least a quarter of a percentage point at its next meeting June 24-25 in a bid to energize the economy and help ward off even the threat of a deflation outbreak.

The Fed "has much latitude to buy insurance for recovery by easing -- and at the same time add to Mr. Greenspan's firebreak against deflation," said Maury Harris, chief economist at UBS Investment Research.

Economists view deflation as a far more serious threat than inflation because the Fed's primary tool for boosting economic activity, reducing interest rates, might have only a limited impact on the psyche of consumers and businesses once a deflationary spiral takes hold.

Japan, for instance, has been unable to get rid of a long-standing deflation problem and turn around its economy despite having driven interest rates to zero.

"I do not believe that the United States is at the brink of significant and sustained deflation," Fed Vice Chairman Roger Ferguson said Wednesday. "But as the Japanese experience shows, the onset of deflation can be unexpected, and so to leave the topic unexamined would be imprudent."

The PPI measures the prices paid to factories, farmers and other producers. For a producer, falling prices for something he sells means more of a squeeze on profit margins.

Businesses, still wary about the uneven recovery and waiting for profits to improve, have been reluctant to make big commitments to capital spending or hiring. That's the major force restraining the economy's ability to shift into a higher gear and stay there.

For many companies, though, falling prices for energy means less expensive energy bills and less of a strain on budgets. Energy prices fell by 2.6 percent in May, adding to an 8.6 percent decline in April.

Costs for men's and boy's clothing dropped 0.9 percent in May, and prices for heavy trucks dropped 0.8 percent, the biggest decline since February 2001.

Excluding food and energy costs, core wholesale prices edged up 0.1 percent last month. But for the 12 months ending May, core prices dipped 0.1 percent.

"There is clearly more worry about deflation than inflation," said David Wyss, chief economist at Standard & Poor's.

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On the Net

PPI report: www.bls.gov/