Inflation Falls: Is the Economy Saved or Doomed?

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Gas prices fell last month, prompting the first drop in overall prices in a year. (Lucy Nicholson / Reuters)

Inflation in June fell for the first time in a more than a year. The Consumer Price Index (CPI), which is the government’s most widely watched gauge of what the things average Americans buy cost, fell 0.2% last month. The drop was mostly driven by a fall in gas prices, which were down nearly 7% alone in June. The question is whether this is a good sign for the recovery, or another sign that we are headed for a double dip. Are we at the end of the soft patch, or the beginning of a worse patch?

For much of the past year, inflation has been the recovery’s biggest boogieman. Many said higher food and gas prices were slowing spending. And indeed, consumers seemed to be opening their wallets late last year and in January. That spending, though, came to a grinding halt in February and March. And that is exactly the time when gas prices in particular started to rise. The economic recovery has slowed since then suggesting that indeed rising inflation was a problem.

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But here’s the rub: Inflation, as long as it is relatively modest, is the sign of a health economy. Higher inflation means there is higher demand in the economy. When consumers are buying, stores can boost prices. And they have until last month. Indeed, even with June’s drop, prices are nearly 4% higher than they were a year ago.  But when inflation zooms higher, that’s a problem. So the acceleration early this year got people nervous, especially at a time when the economy remained weak. No growth and rising prices is a problem.

So the hope is that the drop in prices will lead to spending again. So far that doesn’t seem to be the case. June is typically one of the biggest shopping months of the year. But earlier this week we found out that last month, retail sales fell. Combine that with today’s news and the picture is that stores were cutting their prices in June and they still couldn’t get people to buy. That’s not a good sign.

To be sure, Ben Bernanke and other economists at the Federal Reserve have long argued that the CPI is not a great measure of inflation. Instead, they prefer something called core CPI, which excludes food and energy prices, which tend to be volatile. People complain that’s cheating because food and energy are something we all have to buy, so excluding them doesn’t give you a great sense of where prices are headed for the average consumer. Nonetheless, the core CPI rose this month, up 0.3%, which was actually slightly higher than was expected. So by that measure, demand and the economy continue to be growing.

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Perhaps the best news to come out of falling inflation is that it gives the Fed more cover to enact new stimulus measures. On Wednesday and Thursday, Bernanke testified in front of Congress. He said the Fed was unlikely to repeat its bond buying program, the last round of which was called QE2, in a new effort to lower interest rates. He said that conditions in the economy were different this year than last. The biggest difference he said was growing inflation. But if inflation eases then, one of the main objections to QE3 could be off the table. And that is a good thing. If today’s inflation report is saying the same thing as the horrible jobs number we got last week – namely that the economy is in a protracted funk – then any stimulus we can get would be good.

Stephen Gandel is a senior writer at TIME. Find him on Twitter at @stephengandel. You can also continue the discussion on TIME‘s Facebook page and on Twitter at @TIME.

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