The Consumer Price Index (CPI) fell in June for the third straight month, dropping 0.1% after declines of 0.2% in May and 0.1% in April. Thus over the last three months, prices at the consumer level are falling at an annualized rate of 1.5%.

Over the longer term, though, things are not quite that dire, with the year-over-year change at a positive 1.1% and the six-month change at -0.3%. Still it is a pattern that suggests that the risk of deflation is much greater than the risk of runaway inflation.

However if one strips out the volatile food and energy components to get core inflation, prices rose by 0.2%, accelerating from the 0.1% posted in May and the 0.0% in April. Over the last three months, core inflation has been running at 1.2%, at 0.6% over the last six months and is up 0.9% year over year.  Without a doubt, that is low inflation, but at the core level the evidence is not as strong that we are slipping into actual deflation.

Energy’s Role

Energy, and more specifically energy commodities like gasoline and heating oil, are the reason for the difference. Overall energy prices (including both energy commodities and energy services like electricity) dropped by 2.9% in June on top of a 2.9% decline in May and a 1.4% drop in April. That compounds out to an annualized decline of 25.7% over the last three months and a 9.9% decline over the last six months.

Year over year, though, energy prices are still up 3.0%. Energy commodities were even more extreme, falling 4.1% in June to be down for five straight months now. The three-month annualized change is a decline of 36.2% and the six-month change is a drop of 16.1%. Energy service prices fell by 1.6% in June, to make it three drops in a row and a three-month rate of decline of 9.9%, but prices are still up 0.7% year over year.

Food Prices Expected to Fall?

Food prices, though, have been relatively well behaved, unchanged in each of the last two months after being up 0.2% in April and up 0.7% year over year.  While food prices at the consumer level are not pointing to deflation, they are also not pointing to run away inflation either. However, it should be noted that the main reason for the bigger-than-expected drop in the headline PPI yesterday was falling food prices, so we might see a drop in food prices at the consumer level next month.

0.1% Core Inflation Caused by…Housing

Core inflation came in a bit higher than expected (the consensus was at 0.1%). The main reason for the higher-than-expected number was the cost of shelter actually rose 0.1% due to 0.1% increases in both rent and owner’s equivalent rent (OER). Together, rent and OER make up almost 32% of the overall CPI and over 40% of the core CPI.

Given the weakness in the housing market, most people had expected that rents would be unchanged or actually show a slight decline. Both the regular rent paid to landlords, and the rent you pay yourself for living in the home you own (OER) were unchanged in both May and April. Over the last year, regular rent is unchanged and OER is down 0.2%.

Housing prices as tracked by, say, the Case Schiller Index have only an indirect effect of housing inflation. Housing prices stabilized in the spring due to the first time buyer tax credit, but now that it has expired, it is likely that the price of houses will start to decline again, although probably not at the sort of rate that they were falling in 2008 and 2009.  Eventually that will filter through to OER.

Healthcare Inflation Still Outpacing

Looking down the long list of items in the report, it is hard to find any areas of significant inflation, particularly over the last three months. The price of medical commodities (drugs, for example), which is almost always a higher-than-average inflation area, was unchanged in June and is only going up at a 1.1% rate over the last three months, although medical commodity prices are still up 3.3% year over year. Medical service (hospital visits, for example) prices rose 0.4% for the month but are only up at a 2.8% rate over the last three months and 3.5% over the last year.

While the fact that health care inflation still exceeds overall inflation does pose a long-term challenge. After all, it is health care costs that are the most important factor in the long-term structural budget deficit by a very large margin. Still, even having health care inflation running at 3.5% or less year over year, and showing signs of decelerating, is much better than we have been accustomed to seeing over the last few decades or so.

Unlikely Sources of Inflation

There are only a few areas of the economy that are showing any significant inflation. The most inflation is actually in the prices of used cars, which rose 0.9% in June and are up 16.1% over the last year. Prices of new cars, on the other hand, were up just 0.1% for the month and 1.3% year over year. That differential has to, at some point, be self-limiting. If it were to continue, eventually the price of a 2005 Toyota (TM) Camry would exceed the price of a 2010 Camry.

The other area showing significantly higher prices is tobacco, where prices rose 1.0% in June on top of a 1.3% rise in May and are up 8.0% year over year. Yes, Altria (MO) has more pricing flexibility than most firms, but most of those price increases are due to higher taxes, not just the tobacco companies jacking up prices on nicotine addicts.

Education is another area where prices are going up much more than in the overall economy, with prices rising by 0.4% in June and up 4.8% year over year. Most of the education market is either government run or non-profit, but the relatively high inflation in education might be an opportunity for some of the for-profit firms like DeVry (DV).

So are we falling into deflation? At this point, given the rise at the core level, I would have to say no. However, that is clearly where the risk lies, not the risk of runaway inflation.

The low inflation will allow the Fed to keep interest rates low for a very long time, at a minimum through the end of this year, and perhaps well into 2011.  If prices start to decline more, the Fed has to be ready to further increase the money supply through additional quantitative easing, such as buying more mortgage backed paper or longer term t-notes.

Deflation is an insidious force in the economy because it causes spending to slow dramatically. After all, why buy something now if it is going to be cheaper next month and even cheaper than that two months from now? When that starts to happen, goods start to pile up on the shelves, and then production has to slow down. That forces more people out of work and leads to even less demand. A self reinforcing downward spiral gets underway.

Not only that, but it raises the real interest rate, and debtors find it harder to come up with the cash to pay their debts, eventually leading them to default. Thus it is imperative that the Fed avoid deflation at all costs. We are not there yet, but we are coming too close for comfort.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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