How the US avoided a deflationary funk

Last night the economic focus was on inflation with the December CPI released in both the eurozone and in the US and the data revealed yet another month of becalmed inflation.

This is good news. Neither inflation or deflation are anywhere to be seen.

The US CPI was unchanged in December to be 1.7 per cent higher than a year ago, while the core inflation rate, which excludes food and energy prices, rose 0.1 per cent in the month to be 1.9 per cent higher than a year earlier. The annual rise in the core CPI in the US has been below 2 per cent since 2008 and has not been above 2.5 per cent since the 1990s.

In the eurozone, the annual CPI rose 2.2 per cent while the core rate rose by just 1.5 per cent. The core CPI in the eurozone has been below 2 per cent for a decade.

The banking and housing crisis and the resulting "Great Recession” has certainly meant inflation was going to remain low. In the US, the fear in 2008 and 2009 was deflation as its economy was spiralling towards depression. This deflation fear was the catalyst for the Federal Reserve and its Chairman Ben Bernanke to cut interest rates to zero, provide almost unquestioned financial support for banks and to implement trillions of dollars of quantitative easing.

In the eurozone it was a little different with the European Central Bank slow to cut interest rates (they are still at 0.75 per cent) and slow to deliver QE. This policy lethargy explains, in part, the ongoing economic malaise in Europe at a time when the US is clawing its way to a slow but increasingly sure recovery.

Indeed, the US inflation data overnight and in the past year shows just how effective the Fed's policies have been. The US economy did not fall into a deflationary funk. Not only that but the US economy is growing, albeit moderately, some jobs are being created and the unemployment rate has dropped by more than 2 percentage points from the peak. Things aren't great, but they could have been a great deal worse had the Fed not taken the radical action to fend off deflation.

In Europe, it looks like fourth quarter GDP will be negative and the unemployment rate rose to a record high in December. That said, the core inflation rate, not surprisingly, is below that of the US, a point which helps to explain the strength in the euro against the US dollar.

For the moment, inflation does not matter much to the Fed, or for that matter most other central banks in the G7 countries where the central banks effectively prop up governments, banks, employment and the corporate sector.

The Federal Reserve has recently recalibrated its policy target with the labour market now in focus. In 2012, it committed to keep interest rates at "exceptionally low” levels and to continue expanding QE until the unemployment rate falls to 6.5 per cent. The most recent unemployment rate was 7.8 per cent.

In other words, monetary policy in the US is being directed at inflating the economy and lifting the pace of job creation. The macroeconomy, on the other hand, is still some way from providing the backdrop that would allow inflation to break out. Indeed, the Fed wants to see the macroeconomy tighten so that inflation risks materialise. Only when this happens and there appears to be a legitimate inflation risk will the Fed will reverse the monetary policy focus. This will only occur once the unemployment rate falls below 7 per cent and core inflation moves above 2.5 per cent for a couple of consecutive months. It could be well into 2014 before this happens.

Another indicator that inflation is well contained is the evidence that commodity prices remain range bound. The Reuters/Jefferies CRB index of commodity prices has been remarkably stable for a couple of years. Despite the odd run up or down, its currently at the same level prevailing during the middle of 2011. If inflation pressures were brewing, it would most likely show up in a broad commodity price pick up.

Next week, it will be Australia's turn for an inflation update. The December quarter CPI is set for release and it is likely to show annual inflation around 2.4 per cent in headline terms and around 2.2 per cent in underlying terms. Both these readings include some impact of the carbon price which came into effect on July 1, 2012. In terms of the forecast 2.4 per cent annual headline inflation rate, around 0.6 percentage points of that will be due to the carbon price. In other words, the ongoing inflation rate is very low, probably below 2 per cent despite on-going solid private sector economic growth and a low unemployment rate.

Unlike the Fed, the Reserve Bank of Australia still has the cash rate at 3 per cent having cut it from a recent peak of 4.75 per cent in November 2011. The low inflation climate is clearly a factor that will give it the scope to further cut interest rates if it sees fit.

But that is the interesting issue coming into the February RBA board meeting. Since the December interest rate cut from the RBA, there is no doubt global economic conditions have improved. Financial markets are also stronger and some Australian specific commodity prices are sharply higher.

On the domestic data front, some of the labour market indicators are a touch weaker, but housing is turning higher. Consumer demand remains firm, but business investment looks strong.

There are still a range of top tier data releases to come between now and the RBA's February interest rate decision. If the inflation data next week is as benign as currently forecast, an interest rate cut will be on the table for consideration with judgments over the pace of growth to determine whether or not that rate cut is delivered.