Warning: Falling price zone ahead

Deflation has become the No. 1 fear of a growing number of economists, who worry that lower prices will further hurt the economy.

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By Chris Isidore, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- Rarely has the potential for lower prices been so scary.

While many cash-strapped Americans would welcome paying less for what they need to buy, many economists now say the possibility of deflation, or lower prices, is the greatest threat to the U.S. economy.

And more deflation warning bells are ringing.

On Thursday, the government reported that the Producer Price Index, which measures inflation on the wholesale level, fell on a year-over-year basis for the first time in five years.

The Consumer Price Index, the government's key inflation reading, is due out Friday. Economists expect a decline in overall prices for the month of December.

Some economists are forecasting the first year-over-year drop in the CPI since 1955. As recently as July, the CPI was up 5.5% over the previous 12-months.

Economists worry about deflation because it is a sign of the ever-weakening demand for products. But it can also be a further drag on economic activity by cutting into the willingness of both businesses and consumers to start spending again.

Businesses worried that the price of their products may continue to drop would be likely to cut back production. That can lead to additional plant closings and even more job losses. And even consumers who don't lose their jobs are likely to delay purchases, particularly of large-ticket items, if they think lower prices lay ahead.

Deflation was evident in both the Great Depression and the so-called "lost decade" that left Japan with a stagnant economy in the 1990s and earlier this decade.

"The mere concern of a deflationary cycle taking hold can cause it to become a reality," said Bernard Baumohl, chief global economist for the Economic Outlook Group. "And once you fall into the cycle, it's very difficult to get out."

Investors have quietly have started pricing in deflationary expectations for the coming year. According to a market run by financial information firm Tullett Prebon Information, investors are now betting on a 4.25% drop in U.S. prices over the next year, and lower prices lasting for the following three years as well.

In addition, the five-year Treasury note now has a slightly lower yield than its inflation-protected counterpart, signaling that investors are betting that overall prices in 2014 will be at or a bit below today's levels.

So far, recent price declines in the CPI and PPI have been driven primarily by lower oil and gasoline prices. Some economists say that the falling price of one commodity, like oil, can not cause a deflationary cycle, especially at a time that the Federal Reserve and other central banks are pumping so much money into the financial markets.

Charles Plosser, president of the Federal Reserve Bank of Philadelphia, dismissed the threat of deflation in a speech Wednesday.

"I am not particularly concerned about the possibility of persistent deflation," he said. "When oil and commodity prices stabilize, the negative rates of inflation we have seen in the CPI are likely to disappear."

Deflation not here yet but it's getting closer

But other economists worry the deflationary pressures are already spilling over into other sectors.

The so-called core CPI was down 0.1% in October and was unchanged in November. While the consensus forecast is for a 0.1% increase in December, if it's flat or lower in the month, it would be only the second three-month drop in that closely watched reading in the 52 years the number has been tracked.

"Those who think this is just about oil, I'd say, stick around and watch. It's going to reach all levels of the economy," said Kevin Giddis, managing director of fixed income at Morgan Keegan. "This is going to affect the day-to-day business of just about everything."

Baumohl said he's still hopeful a deflationary cycle can be avoided with the help of the unprecedented actions by the Federal Reserve and a potential stimulus package from Congress. But he concedes that if that if those efforts to spur spending aren't successful, then the risk of deflation soars.

To be sure, even deflation hawks agree that it's premature to say that falling prices are a major problem just yet. A few months of narrowly declining consumer prices don't necessarily indicate the start of a deflationary cycle.

And the price declines of the past few moths are relatively mild when compared to what happened during the Great Depression. There were year-over-year drops of about 10% every month from March 1931 to April 1933.

But Lena Komileva, head of G7 market economics for Tullett Prebon, said that by the time year-over-year CPI does turn negative, policymakers "won't be able to respond fast enough to prevent deflation from developing."

She said economists have generally underestimated the risks to global economic growth for much of the last year, and warned that it is very dangerous not to take the threat of deflation seriously.

And while the Fed and other central banks are usually able to combat inflation effectively by raising interest rates, there is no simple cure for deflation, especially when interest rates already are near zero as they are in the U.S.

"Deflation is a self-feeding phenomenon and the world simply lacks ability to fight deflation the way it can fight hyperinflation," she said. To top of page

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