Despite Tuesday’s hotter than expected U.S. consumer inflation report, economists at CIBC World Markets warn that deflation could still be a problem.

Economistss Avery Shenfeld and Benjamin Tal say “The minimal pace of inflation now, and the forces acting on its future direction — point to a more material risk of at least a temporary dip into negative territory, enough to keep alive the fears of a Japan-style deflation trap.”

CIBC says that the risk of deflation is readily apparent, based on close inspection of current inflation measures. It says that over the past six months, the 12-month core CPI and the core personal consumption deflator, both ran at a mere 0.9% annualized. “Deflation isn’t here yet, but given the typical volatility in these series, it isn’t that far away either,” says the pair.

They says that the threat of deflation is Economics 101. “An economy operating with substantial slack — low capacity use rates, rising unemployment — will see downward pressure on pricing power and inflation.”

“For American retailers, deflation isn’t a risk, but a reality. Strip out gasoline stations, and retail prices have been falling for two years running,” notes the pair. “With goods prices already deflating, services are the obvious candidates for further disinflation. Indeed, the real estate boom, and its impact on housing services, has been the most important factor keeping core inflation above water.”

They says that as mortgage rates bottom out later this year, housing prices will top out. “In fact, that process is already underway, with housing price inflation slowing dramatically in recent months. Rents are following suit, currently rising by only half the pace seen in early 2001. And given the current momentum in the real estate market, rent prices might stop rising altogether in the coming six to twelve months, stripping the last line of defense against deflation.”

“Add it all up, and what we’ve already experienced in core goods prices is likely to be seen, at least for a few months in early 2004, in the overall headline CPI. On their own, economic slack and an easing in rents would push core inflation to zero. But the modest inflationary impact of the US dollar1s slide will put a floor on core CPI at 0.5%,” it says. “By the first quarter of 2004, with crude oil prices likely near $25/bbl, the energy component will push the overall CPI below the core rate, and just slightly into negative territory, for the first time in five decades.”

“That in itself won’t yet add up to a prolonged, Japanese style deflationary trap. But as it develops, it will be more than enough to turn what the Fed now calls a ‘minor’ risk into a major worry,” they predict.