Annual Core Inflation Drops to 0.6%, the Lowest Ever

The nation's struggle to prevent deflation is apparently only just beginning. Consumer prices rose a less-than-expected 0.2% in October, with the core rate -- which excludes often-volatile food and energy prices -- unchanged for the third straight month. Equally significant, the 12-month core rate fell to 0.6% in October from 0.8% in September -- the lowest year-over-year core rate in the consumer price index's history, which dates back to 1957, the U.S. Labor Department said.

Including food and energy, the overall 12-month inflation is running at a 1.2% rate, slightly higher than the 1.1% year-over-year rate recorded in September. A Bloomberg survey had expected overall consumer prices to rise 0.4% in October and the core rate to tick up 0.1% , after an 0.1% overall increase and no change for the core rate, respectively, in September.

Inflation Too Low For The Fed

Moreover, October's CPI data are likely to support the Federal Reserve's latest quantitative easing program to both stimulate the U.S. economy (and create jobs) and prevent deflation. The Fed wants a little more inflation in the economy.

The reason? Deflation, a protracted, systematic decline in prices, robs companies of revenue and can lead to the dreaded deflationary spiral, in which price cuts lead to lower corporate revenue, prompting more layoffs, leading to further consumer-spending declines, prompting more price cuts and so on. Deflation took hold hold during the Great Depression of the 1930s, making that economic disaster even worse.

That threat, and the economic recovery's subpar GDP growth, are the two main reasons the Fed has expanded its quantitative easing program by up to $600 billion in additional asset purchases, via a second phase, the so-called QE2. The Fed says it expects to buy a maximum of $110 billion in assets per month, but it could be less.

Fed's Lockhart: QE2 Designed To Strengthen Economy

During a speech on Tuesday in Atlanta, Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said QE2 has two goals: to prevent deflation, whose capacity to damage the U.S. economy is greater than inflation; and to increase overall demand and strengthen the economy. Lockhart added that QE2 wasn't undertaken to decrease the dollar's value, noting that "the most critical factor in maintaining the dollar's value is a strong U.S. economy with stable inflation, which is also in the world's interest."

Judging from October's CPI report, the Fed still has a ways to go prevent deflation from taking hold: Strip out the volatile food and energy component, and price weakness abounds.

In October, energy prices jumped 2.6%, including a 4.4% surge in gasoline prices, 4.7% jump in fuel oil prices and an 0.4% increase in electricity costs. Food prices rose 0.1%. But elsewhere, the softness was pervasive. Medical care services rose 0.2%, shelter costs edged 0.1% higher, furniture prices were unchanged, recreation costs fell 0.1%, education costs declined 0.1%, personal care prices fell 0.2%, commodity prices (excluding food and energy) declined 0.2%, new-vehicle prices fell 0.2%, clothing costs declined 0.3% and used cars/trucks prices plunged 0.9%.

Greater Risk Remains Deflation

October's consumer price report revealed that the U.S. economy continues to experience low inflation -- too low from the Fed's standpoint. The risk of deflation and its potential debilitating consequences on the economy remains clear. So far price hikes in key commodities such as crude oil, grains and cotton haven't ratcheted up consumer-level inflation. And if commodity price trends reverse, that would only put more downward pressure on consumer prices.

So, from the inflation perspective, the Fed will be able to stick to its expanded quantitative easing policy at least through the first quarter of 2011. At this point in the expansion, the greater risk remains deflation, not inflation.