Deflation Fears Strike the Dow as Energy Falls Again

Inflation might well have been whipped too well. Image: Gerald R. Ford Presidential Library & Museum, via Wikimedia Commons.

Stocks performed badly on Friday, as further weakness in the oil market took its toll on investor sentiment. Moreover, the latest reading of prices at the wholesale level added fuel to arguments that deflationary pressures are starting to take hold, posing a new threat to economic growth and causing even more uncertainty about the Federal Reserve's future course for monetary policy. By 11:15 a.m. EDT, the Dow Jones Industrials were down nearly 200 points, giving back much of Thursday's gains as the market continued the week's volatile swings.

Is deflation coming? The Producer Price Index for February extended its downward streak this morning, as the Bureau of Labor Statistics reported that prices for final demand fell 0.5%. The release marked the fourth consecutive monthly drop in producer prices; since July, the index has fallen by roughly 1.8%.

Energy prices have clearly played a key role in the decline, but prices have been weak elsewhere as well. Even taking out volatile food and energy costs, the core PPI has only risen in one month out of the last five, and that was a tepid 0.1% increase.

Further down the supply chain, price changes have been even more dramatic. The price of processed intermediate goods is down more than 6% over the past 12 months, while the price of unprocessed intermediate goods has plunged 25% since this time last year. Services haven't seen the same price declines as goods, but the stability in services prices could not offset plummeting commodity prices.

Price drops at the wholesale level usually take time to filter down to consumer prices, but we've already seen some signs of sluggish behavior in the CPI as well. From September to January, consumer prices have fallen 1.8%, and price levels are lower than they were a year ago.

Fed Chairwoman Janet Yellen has a tough decision to make. Source: Federal Reserve.

Hitting the economyPrice changes are even more important right now as the Federal Reserve considers its next move on monetary policy. On one hand, signs of economic expansion have pushed the Fed to signal potential rate hikes that could start by summer. Yet with inflation running well below its 2% target, the central bank doesn't want to take action that might stifle price increases and fend off deflation.

From all indications, moreover, energy could provide even more of a push downward in prices. Crude oil fell back below the $46 per barrel level this morning, as harsh winter weather finally gives way to more moderate spring-like conditions and reduces demand. Both ExxonMobil and Chevron fell roughly in line with the Dow's percentage drop, but smaller energy stocks posted bigger declines as hopes fade for a quick rebound for energy prices.

After such a huge move upward for stocks in recent years, even a hint of deflation is enough to make many investors nervous about the sustainability of the bull market. Until the Fed picks its next direction, uncertainty could produce more volatility like that seen this week.

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