Spectre of deflation haunts US and Europe

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The Independent Online

Factory prices in the United States fell sharply last month, triggering new fears that America is now threatened by deflation and seemingly supporting the Federal Reserve's warning last week of an "unwelcome and substantial fall in inflation".

The 1.9 per cent fall in prices paid to US factories, farmers and other producers was more than double economists' forecast and followed a 1.5 per cent rise in March.

Prices excluding food and energy, or the so-called core rate, fell 0.9 per cent, the most since August 1993, after rising 0.7 per cent the previous month. This reflected falling prices for cars, trucks, men's and boy's clothes and cigarettes. The raw materials and semi-finished goods indexes each fell by the most on record.

The gloom was compounded by figures showing that growth in the eurozone ground to a halt in the first quarter of 2003 as Germany headed towards recession

The eurozone economy put in its worst performance in just over a year as unexpected contractions in Germany and Italy took two of the region's biggest economies to the brink of recession.

The US figures yesterday – indicating that there is too much supply chasing too little demand from consumers – will only add to concerns that the US economy is facing a period of enduring weakness.

If this is the case – as most signs seem to indicate it is – the statement by the Federal Open Market Committee (FOMC), the US Federal Reserve's policy-making body, could signal a historic break.

As Robert Samuelson, wrote last week in Newsweek: "Since the early 1960s, inflation (which peaked at 13.3 per cent in 1979) has dominated the economy. Its rise and fall affected interest rates, the stock market and wages. Demoting inflation's importance means we've entered a new era with unfamiliar threats."

Last week the Federal Reserve left short-term interest rates unchanged but set the stage for a cut if the economy shows no sign of improvement when policy makers next meet in June. Given the state of the economy, the decision to hold the overnight federal funds rate at a 41-year low of 1.25 per cent had been expected by traders. But the central bank issued a surprise, if not entirely explicit, warning of the risk of deflation, where falling prices drive the economy into a downward spiral.

The "balance of risk" was weighted towards weakness for the foreseeable future, the FOMC said, downgrading its assessment of the economy from the neutral stance adopted at its last meeting.

And in a key passage of its statement, the FOMC warned that "the concern of the possibility of an unwelcome and substantial fall in inflation, though minor, exceeds that of a pick up in inflation".

There was also a decline in energy prices but it came too too late to help manufacturers in April. Production at factories, mines, and utilities declined 0.5 per cent last month after falling by the same amount in March, the Fed said, the sixth decrease in nine months.

The proportion of industrial capacity in use fell to 74.4 per cent, from 74.8 per cent. It is the lowest since June 1983, when it was 74 per cent.

Joseph LaVorgna, a senior economist at Deutsche Bank Securities, said he believed that manufacturing recently had been under intense economic pressure. "The manufacturing sector has been in recession this year and taken the brunt of the slowdown, the run up in energy costs, and war concerns. Manufacturers have been forced to cut inventories to avoid being caught out if demand fell."