Concerns remain low about possible deflation, but represent a marked change from just six months ago when soaring energy prices threatened to trigger a widening inflation problem that many analysts believed the Federal Reserve would have to fight by raising interest rates.
The Labor Department said Friday that consumer prices dropped 0.7 percent in December, slightly smaller than the 0.9 percent drop economists expected.
For the year, consumer prices edged up by just 0.1 percent, down from 4.1 percent in 2007 and the smallest annual change since consumer prices actually fell by 0.7 percent in 1954. The big yearly improvement occurred because of the sizable declines in energy prices in recent months.
Excluding volatile food and energy prices, so-called core inflation was unchanged in December. For the year, it rose a moderate 1.8 percent, compared with a 2.4 percent increase for all of 2007.
Price pressures have eased as the recession intensified. Further evidence of the slowdown came Friday in a separate report from the Federal Reserve showing that production at the nation's factories, mines and utilities plunged 2 percent in December, capping the worst year for manufacturers since 2001. Last month's drop, double the amount analysts expected, came after a 1.3 percent decline in November, which was even sharper than initially reported.
For all of last year, industrial production declined 1.8 percent, a sharp reversal from the 1.7 percent increase logged in 2007. It marked the worst showing since a 3.4 percent decline in 2001, when the country last suffered through a recession.
For December, gasoline prices fell by 17.2 percent, the largest monthly decline on records that go back 71 years.
Overall energy prices also dropped by record 8.3 percent as home heating oil and natural gas showed declines.
For 2008, energy prices fell 21.3 percent, with gas costs tumbling by 43.1 percent. Food costs were unchanged in December, and rose 5.8 percent for all of last year.
But some large foodmakers have been raising their prices to offset input costs that reached records highs last summer, and it's not clear how much, if at all, those will drop as ingredient costs moderate.
Kellogg Co., the world's leading maker of breakfast cereals, has been increasing the price of its products, like Frosted Flakes, and competitors with less market share have followed suit, UBS analyst David Palmer. The "substantial pricing action" Kellogg took gives it wiggle room to promote, and play with pricing, as input costs come down, he wrote in a note to clients Friday.
Food companies that have raised prices are better positioned this year because if they have to lower them to match price drops by private label competitors trying to entice shoppers to switch to lower-cost brands, it won't hurt their profit margins as much, analysts said.
Kellogg's most recent pricing action was announced in the fall. Starting next week, there will be low-to-mid single digit percentage price increases on Pop-Tarts and the bulk of the Battle Creek, Mich.-based company's cereal brands, but not All-Bran or Special K.
The sizable slowdown in overall inflation last year gave consumers more spending power. Average weekly earnings, after adjusting for inflation, rose 2.9 percent last year, a big improvement from 2007 when average weekly earnings fell 1 percent, the government's CPI report showed on Friday.
However, the typical household may not feel those benefits as they watch the value of their homes and stock holdings plunge, and see job layoffs soar.
The big declines in overall prices in recent months came after soaring energy and food prices in early 2008. But the worst financial crisis since the 1930s sent the economy into a tailspin in the fall. The Fed is now focused on trying to ensure the financial turmoil does not push the country into a severe and prolonged recession.
The Fed cut a key interest rate to nearly zero last month and economists believe it will keep rates at that level over the next year, until the economy begins to show signs of recovering.
"Inflation is way down on the list of worries right now," said David Wyss, chief economist at Standard & Poor's in New York. "The worry right now is getting the economy to rebound."
Any Fed worries about inflation have evolved into concerns about possible deflation, a prolonged bout of falling prices, which has not been seen in the U.S. since the Great Depression.
Wyss ranked the possibility of deflation as low, but said the risk could rise significantly if the current financial crisis and recession worsen significantly in coming months.
To keep that from occurring, President-elect Barack Obama has pushed Congress to release the second half of the $700 billion financial rescue package, gaining a victory on Thursday when the Senate rejected an effort to block release of the second $350 billion.
Obama also wants Congress to pass a sweeping economic stimulus bill. House Democrats, working closely with Obama, on Thursday unveiled a proposal calling for $825 billion in federal spending and tax cuts over the next two years to revive the moribund economy.
Economists believe inflation will slow even further this year as long as energy prices don't shoot up again. While a global recession is expected to depress energy demand, analysts said a supply disruption in the volatile Middle East is always a threat that could send prices higher.
Oil prices are more than $100 per barrel below their all-time high of $147 a barrel hit in mid-July. Average gas prices are around $1.80 per gallon, compared with $3.05 a year ago, according to auto club AAA, the Oil Price Information Service and Wright Express. Analysts predict gas prices will fall in coming months, further helping to contain inflation.
While the big drop in prices at the pump acts like a tax break, giving consumers money they can spend elsewhere, the weak economy and soaring layoffs are keeping them from spending in other areas. That has translated into tough times for the nation's retailers.
This week alone, department store chain Gottschalks Inc. put itself up for sale and said it had filed to reorganize in a Chapter 11 bankruptcy, discount clothing chain Goody's Family Clothing filed for Chapter 11 protection, luxury retailer Tiffany & Co. lowered its year-end profit forecast and Neiman Marcus Group Inc. said it was cutting about 375 jobs. Last week, Macy's Inc. said it will close 11 underperforming stores in nine states, affecting 960 employees.
Also last week, Wal-Mart Stores Inc. reported smaller-than-expected sales gains in December. Other retailers, including Sears Holding Corp., which operates Sears and Kmart stores, Saks Inc. and Gap Inc. reported big sales declines, wrapping up the worst holiday shopping season in at least four decades.
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