Rate cuts fuel deflation fears

The Fed cut its target federal funds rate on Dec. 16 to a range from 0 percent to 0.25 percent.

“They’re acknowledging reality,” says Joseph Trevisani, chief market analyst for New Jersey-based forex broker FX Solutions. “Everybody knows the effective rate has been there for some time.”

The historic low came at a time when inflation was decreasing at record levels, bringing on new worries about the risk of deflation. November Consumer Price Index (CPI) data, also released on Dec. 16, showed a 1.7 percent drop. This drop was preceded by a 1.0-percent drop in October.

The Bureau of Labor Statistics (BLS) attributes much of this drop to the decline in energy prices. In November alone the BLS’s energy index fell 17 percent, capping four months of decreases and doubling the October drop. The next-largest declines occurred in transportation, which fell 9.8 percent in November, and housing, which fell 0.1 percent.

Nonetheless, the November CPI was 1.1 percent higher than the November 2007 reading. However, the 12-month change in July was at 5.6 percent, when crude oil prices were at their peak.

Looking beyond the energy factor, Trevisani says the real type of deflation the Fed should be fearful of is the “feedback loop.”

“Prices fall and then people expect them to fall so they hold off purchasing. This drops consumption, which drops employment,” Trevisani says.

Companies try to combat muted consumption by lowering prices and employing fewer workers. Unemployment in turn perpetuates less consumption, further fueling the downward spiral.

“But for the moment, I don’t see that happening,” he says.