Deflation Still Clear and Present Danger

Deflation, the economic beast many feared would devour the next decade, appears to have been vanquished.

Or has it?

Superficial signs of renewed inflation are everywhere: Oil prices appear to be stabilizing, and concern is growing about future supply shortages (which, by extension, could lead to higher prices at the pump). The stock market has staged an impressive rally, with expectant bulls and former bears finding "green shoots" of economic growth everywhere. Home prices -- if you look purely at the data and ignore fundamentals -- are starting to slow their fantastic decline.

Even the consumer price index, or CPI, is looking tame. Well, except for last month's drop, the largest in more than 50 years.

And herein lies the problem.

The CPI, the market's favorite inflation gauge, has been masking the structural deflation in our midst since the housing market fell of its wheels almost 4 years ago. Given the precipitous drop in property values, one would naturally expect the housing component of the CPI to fall in kind. Not so.

The statistical alchemists, err, experts, at the Bureau of Labor Statistics use something called "owners equivalent rent," OER, to measure consumer housing expenses. OER tries to approximate the cost to rent the country's typical home, and according to the Wall Street Journal makes up 24% of the CPI and 31% of the core CPI, which backs out food and energy costs.

And since even as property values have slid in record-breaking fashion rents remained buoyant, OER has vastly understated the drop in home prices. This means the CPI -- were it to reflect some sort of economic reality -- would have fallen more than it actually has.

As the housing slump rolls on, the pain is increasingly being felt by landlords, not just owner occupiers. Rents in big cities like New York and San Francisco are already dropping, as would-be tenants demand concessions from property owners. Vacancies are increasing, as even those driven from the housing market by foreclosures and the tight mortgage market can't fill up empty apartments, condos and track homes.

Drive around suburbia and "For Rent" signs are nearly as common as "For Sale" signs.

Rents are likely to keep falling and as a result, OER could begin to drag down the CPI. Of course, statisticians can and likely will play games with adjustments for volatile energy prices (renters often don't pay for utilities, so energy costs are backed out of OER). Further, government bean counters are even considering adapting OER to reflect new, high levels of home ownership (just in time for a reversion to the historic mean, thanks for being ahead of the curve guys).

As long as construing economic data in a way that makes it seem more likely for effectively insolvent financial institutions like Bank of America (BAC) and Citigroup (C) to raise capital and remain in business, that will remain the status quo.

Meanwhile, back in reality, saving is now en vogue, deleveraging is ongoing and the repayment (and destruction) of dollar-denominated debt will keep inflation in check for the foreseeable future. More importantly, the recognition that smaller can be better and less can be more are becoming entrenched in the lives of ordinary Americans.

Don't believe the hype: Deflation isn't going away any time soon.