The Producer Price Index (PPI) fell for the third month in a row. In June it was down 0.5% on a headline basis, following declines of 0.3% in May and 0.1% in April. If one strips out food and energy prices to get to core PPI inflation, it was up 0.1% after back-to-back rises of 0.2% in April and May.

This month it was food prices that showed the sharpest decline, falling 2.2%, a big acceleration to the downside from the 0.6% decline in May and the 0.2% drop in April. Energy prices have also declined for three months in a row, although the 0.5% decline this month was not nearly as sharp as the 1.5% drop in May, or even the 0.8% decline in April.

On a year-over-year basis, inflation was 2.8%, down from 5.3% in May and a peak of 6.0% in March. Most of that inflation happened in the last half of 2009. So far this year, prices for finished consumer goods at the wholesale level are down 0.9%. On a year-over-year basis, the prices for finished capital goods are up just 0.3%.

If we look further up the production pipeline, it does not look like there is that much inflationary pressure.  Prices for intermediate goods (to keep finished, intermediate and crude goods straight, think bread, flour and wheat) fell by 0.9%, more than reversing the 0.4% increase in May. On a year-over-year basis, intermediate goods prices were up 6.4% down from 8.5% in May.

Prices for crude goods fell for the third month in a row, dropping 2.4% on top of drops of 2.8% in May and 1.2% in April. Crude goods are essentially commodities, and as such tend to be very volatile in their pricing. Year over year they are up 13.3%, but that is down from up 21.2% year over year in May.

This report is one more indication that inflation is not a problem right now, and that those who feared the big expansion of the Fed balance sheet in response to the financial crisis would lead to high inflation were dead wrong. It appears that the much bigger threat to the economy now is deflation.

Very few finished consumer good areas are showing any significant price increases on a year-over-year basis at the wholesale level. Outside of food and energy, the only categories of goods that have seen prices rise by more than 5% over the last year are Jewelry up 12.2% (reflecting the rise in the price of gold), Tires up 8.4% and Tobacco up 7.4%. That pricing flexibility is probably good news for the likes of Altria (MO) and Goodyear (GT). 

Deflation raises real interest rates and significantly slows the economy. If people think that prices are going to fall, they hold off on spending and wait. Firms then see goods pile up on the shelves and have to cut prices further, or cut back on production and laying off people in the process. Deflation of 5% is far more damaging to the economy than inflation of 5% would be.

The current readings on inflation suggest that the Fed will keep short-term rates at 0 to 0.25% for a very long time, certainly through the end of this year. It also means that they should be actively considering further moves to ease monetary policy. That could include the purchase of more mortgage-backed paper, or perhaps open market operations involving longer-term government debt. In essence, the data is saying that the money supply needs to be increased and needs to be increased soon. If not, the danger of a Japan-style lost decade increases significantly.

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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