Inflation hits landmark low, has nowhere to go but up

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The July inflation report, released this morning, will likely go down as something of a landmark: the Consumer Price Index fell 2.1% over the previous 12 months, the biggest year-over-year drop since 1950. This was entirely due to a 28.1% drop in energy prices over that period, and as energy prices began falling in August 2008, the year-over-year price drop will begin narrowing next month. Negative 2.1% will stand as the low point for inflation in this economic cycle.

Then what happens? The current inflation trend, as represented by the once-mocked but now obviously pretty useful “core” inflation number (which excludes food and energy) appears to be a little under 2%—year-over-year, core inflation was at 1.5% and over the past three months the annualized rate has been 1.7%.

Where’s inflation headed after that? I don’t think anyone has the faintest idea yet. A strong economic recovery and accompanying increase in the velocity of money (that is, all the cash the Federal Reserve has pumped into the financial system actually begins to circulate in the real economy) could result in a quick rise in the inflation rate. The economic data over the past few days, though, show that the strong-recovery story is still mostly just that, a story. Retail sales are down. Consumer sentiment is down. Industrial production is up a little, but mostly because of the temporary cash for clunkers boost to the auto industry. Jobless claims are up.

Still, on the inflation/deflation front, it certainly ain’t the early 1930s all over again. The year-over-year inflation rate quickly went from about zero to -4% in the months following the 1929 stock market crash, then fell below (rose above?) -9% in May 1931 and stayed there until April 1933. According to the Irving Fisher/Milton Friedman monetary explanation of the Great Depression, it was this extreme deflation that caused most of the era’s economic problems—because people who had taken out loans before prices (and wages) started collapsing couldn’t afford to pay them back, and this in turn led to a seemingly neverending banking crisis. Ben Bernanke does appear to have succeeded in keeping that from happening this time around