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Falling fuel prices tame inflation

January 25, 2012

| MoneyRates.com Senior Financial Analyst, CFA

A rare bit of good news on oil prices emerged recently as oil and other energy costs declined for the third straight month in December, according to the latest figures from the Bureau of Labor Statistics (BLS). This development effectively put the brakes on inflation, which rose steadily during parts of 2011.

This cooling-down of inflation offered some immediate benefit to American consumers, and could be a factor in helping the fragile economic recovery gain some momentum.

Inflation takes a break

The BLS Consumer Price Index (CPI) was flat in both November and December, following a slight decline in October. This represents a fairly dramatic reversal of the trend in inflation: Prices had been rising at an increasing rate throughout 2011, bringing the year-over-year inflation rate to 3.9 percent by the end of September. The recent cool-down in the CPI brought the 2011 inflation rate to 3.0 percent -- still twice the rate of the year before, but now falling rather than rising.

Energy prices, which were a big part of the problem early in the year, have been the key to bringing inflation under control in recent months. The energy sector as a whole has now seen price declines for three straight months, with gasoline leading the way with the biggest price decreases. This helped offset increases in several other areas, including food and medical services.

Inflation versus interest rates

Here are four reasons the leveling off of inflation is worthy of notice -- and even applause:

  1. It lets bank depositors gain back some lost ground. Although bank deposits are supposed to be safe, as long as inflation is rising faster than savings account interest rates, depositors are losing some of the value of their money. With inflation slightly negative over the last three months of 2011, bank customers had a chance to get ahead of inflation, even with the rates on CDs, savings, and money market accounts remaining below 1 percent. This doesn't just help those depositors, but it effectively makes more wealth available to fuel the economy.
  2. It gives the housing market some breathing room. The housing market has shown signs of stabilizing lately, but this is largely dependent on record low mortgage rates. If inflation had continued to rise, it is unlikely that banks would have remained willing to make long-term loans at less than the rate of inflation.
  3. It helps consumers deal with modest pay raises. Weekly earnings rose just 2.7 percent in 2011, less than the rate of inflation. Only a more moderate inflation rate will allow consumers get ahead with such anemic pay raises. In turn, giving consumers more room to spend is a key to making the economic recovery sustainable.

Month-to-month inflation numbers can be volatile though. Whether the improvements of the past three months can be sustained will be among the key economic factors of 2012.

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