Deflation, inflation and the U.S. Fed

WASHINGTON (Reuters) – One day after the Federal Reserve got investors thinking about uncomfortably low inflation, Starbucks announced it was raising prices on some of its coffee drinks.

Anheuser-Busch is planning price hikes on some of its Budweiser beers later this year (although it’s also going to give away free samples to 500,000 people at bars and restaurants in the coming weeks).

So is inflation dangerously low or is it creeping higher?

It depends where you look.

The Fed said last week that inflation was below its comfort level and likely to stay that way for some time. The central bank said it was prepared to step in if necessary to ensure that this doesn’t morph into something serious like deflation.

The Fed’s favorite inflation gauge — the ineloquently named core PCE price index — is due on Friday and is likely to show a slight uptick for September, according to a Reuters poll. On a year-over-year basis, the index is expected to hold steady at 1.4 percent, below the Fed’s comfort zone of 1.7 percent to 2 percent.

The measure excludes food and energy prices, which the Fed considers too volatile to provide a reliable signal on future price direction. But food, energy and other major commodity groups have soared in the past couple of months, which explains why companies like Starbucks are raising prices.

The Reuters-Jefferies CRB Index <.CRB>, which tracks commodity prices, hit an 8-month high last week. Gold prices hit a record level and other commodities, including soybeans and cotton, notched multi-year peaks.

This is causing trouble for commodity-sensitive emerging markets such as Russia. Its central bank meets on Tuesday and is widely expected to hold rates steady. But it may express growing concern about inflationary pressures after a summer drought devastated the country’s wheat crop.

It is less clear what these rising commodity prices will mean for the U.S. economic recovery and the Fed’s next policy move. High unemployment and sluggish consumer spending mean many companies cannot follow Starbucks’ lead and pass higher raw material costs along to consumers.

Jason Schenker, president of Prestige Economics in Austin, Texas, says the lofty jobless rate makes consumers “very, very price sensitive,” which means rising commodity prices probably won’t have much of an effect on broader inflation trends.

Oil tends to seep more deeply into consumer prices because it touches each stage of production, from factory to delivery truck to storefront. But it has not risen as sharply as some of the agricultural products or metals.

“Seventy-five dollar oil does not a story make,” Schenker said.

UP OR DOWN?

Inflation at 1.4 percent isn’t exactly Japan-style deflation. Richmond Federal Reserve Bank President Jeffrey Lacker said it’s quite possible for inflation to run between 1 percent and 1.5 percent for a while without slipping into deflation.

But some economists are not so sure. David Rosenberg, chief economist at money management firm Gluskin Sheff in Toronto, thinks deflation is a serious threat, and says the Fed may not be up to the challenge of combating it.

“The current crew of policymakers have only lived their lives fighting inflation and actually have no experience at all in combating deflation,” he said.

Rosenberg sees the building blocks of deflation in the high unemployment rate, the weak housing market and the heavy load of debt that still weighs on household spending.

But he also expects commodity prices to push in the opposite direction, particularly oil and gold, propelled higher by demand from emerging economies, as well as investors seeking safety from either deflation or a weakening dollar.

For the Fed, consumers’ expectations are more important than those of analysts, so the most salient piece of information this week may come from the Reuters-University of Michigan survey of consumers on Friday, which will include questions on inflation expectations.

The latest one-year inflation expectation reading was 2.2 percent, the lowest in a year. If that continues to slide, it could set off alarm bells at the Fed and heighten investors’ expectation that more policy easing will come.

Then again, if people pay more for their Starbucks and beer and start thinking all prices are heading higher, expectations may edge up, which wouldn’t be all that terrible for a central bank worried about ultra-low inflation.