Deflation on the Horizon?

As markets dipped at the end of last week–largely on renewed fears of deflation and the lingering weakness in the industrial sector, specifically auto production–calls continued for more government fiscal intervention. The market moved downward on Friday morning after the government released an assortment of dispiriting economic numbers, but regained its composure by afternoon, ending in positive territory. The Dow Jones index gained 68.73 points, or 0.84 percent, while the S&P 500 was up 0.76 percent and the Nasdaq was up 1.16 percent. The specter of deflation, last characteristic of consumer prices during the Great Depression, might have spooked investors. According to the U.S. Department of Labor, prices dropped 0.7 percent in December, making for an annual price increase of 0.1 percent for all of 2008, the lowest annual rate of inflation since 1954. The annual inflation rate in 2007, by contrast, was 4.1 percent. Much of the deflationary pressure in 2008, however, was attributable to energy prices, which dropped 8.3 percent in December, and 21 percent in 2008, largely after the oil bubble broke in the fall. The other doleful economic statistic for Friday was a decline in U.S. industrial production, which was down 2 percent in December, according to the Federal Reserve. The nation’s industrial capacity-utilization rate now stands at 73.6 percent, the lowest level since 1983. “Manufacturing activity decreased in most districts in the past month, the Federal Reserve said earlier this week in its Beige Book, reflecting “reduced or low activity across a wide range of industries” in most of the country. Much of the decline, again, is attributable to one industrial sector: automobiles. Motor vehicle and parts production dropped 2.5 percent in December. Production of cars and light trucks is at its lowest annualized rate–6.43 million units–since 1982, according to the Fed. In her January newsletter, Diane Swonk, chief economist at Chicago-based Mesirow Financial, wrote that “the consensus on the need for fiscal stimulus is fairly solid among even the most conservative economists. Nobody is will to risk deflation and/or Japanese-style decade-long stagnation.” Still, she said, “economic conditions are still deteriorating. Efforts by the Fed to re-inflate the economy, and a heavy dose of fiscal stimulus will eventually help to reverse those losses. There are no silver bullets, however, and the best we can hope for in the near term is to mitigate rather than reverse entirely the declines we are seeing. “The good new is that we still live in the most flexible and resilient economy of its size that the world has ever known,” she continued. “With time, we will recover.”