More Core CPI Deflation is Inevitable

Posted by Michael A. Kamperman on February 22, 2010

The Core CPI index was reported as minus .1%.  This is the first time since 1982 the core rate has been negative.  It won’t be the last.  We are in store for many more negative Core CPI readings over the next couple of years.  Housing costs in the form of rent and owner’s equivalent rent make up over 40% of the Core CPI rate.  While the government should be using an estimate of actual home prices to calculate the cost of home ownership, it remains wedded to the concept of using owner’s equivalent rent  which was introduced in 1983.  While housing prices were falling dramatically for over 2 years, the CPI calculated the cost of home ownership as rising because rents were rising.  Now the lag effect of the deep contraction in the housing market has spilled over to rents and rents are declining.  Vacancy rates for apartments are now over 8%, and these units are having to compete with recent foreclosures and short sales purchased by investors and turned into rental units.  Hence, the pressure on rents will remain relentless over the next couple of years unless there is a dramatic uptick in employment.  Too many young men and women are graduating from college without the prospect of a full-time job that can cover their living expenses and they are being forced to move back home with Mom and Dad.  Additionally, many pe0ple who are financially strapped are moving in with friends or relatives.  The glut in housing will take a lot longer to work off than most experts expect.

The Core CPI is actually reflecting where we have been.  But troubling to my mind is the more the government reports the country is experiencing deflation, then the more it will become a reinforcing self fulfilling prophecy.  First of all  many wage negotiations are tied to the CPI rate, as is Social Security.  This will lower incomes.  Additionally, as people see and perceive that prices are actually falling they will do the rational economic thing which is to delay purchases.  Fewer purchases will lead to fewer jobs and fewer people capable of buying or renting a house. It is ironic that the Fed wanted to signal to the markets a return to normalcy by raising the discount rate last week only to have a negative print in the Core CPI rate bring in to question any attempt to tighten.  It is only a matter of time before the Fed reverses and resumes its program of quantitative easing, just as it has been only a matter of time before the housing price declines would turn the Core CPI rate negative.  Our country has too much debt, and now it has falling incomes to service that debt.

We are not alone.  In fact we are legion.  Most of Europe shares our fate.  We now share Japan’s deflationary fate of the last 20 years.  Japan sent a clear signal that when economic calamity hits the worst thing to do is to be too timid and then compound the error by propping up too-big-to-fail-too-broke-to-lend Zombie Banks.  The history book on the shelf is always repeating itself….Waterloo.  The Greek led euro crisis indicates deflation is inevitable in Europe as well.  It also has sparked a significant rally in the dollar which is killing any hopes of an export led recovery.  Message to Lawrence Summers, the whole world cannot adopt the Chinese model of selling four times as much as it buys from everyone else.  There is an upside to the negative Core CPI rate.  It will highlight the dramatic decline in the velocity of money and focus attention on the need for the Fed to print more money.