The Risk of Deflation

The debate about whether or not we will get inflation or deflation in the future continues with good arguments on both sides of the issue. Below is summary of a research note published by the Fed that argues against a deflationary spiral. It is short and easy to read. From the WSJ Real Time Economics:

Unemployment is rising, asset values are plummeting and some of the economy's most common products (beyond food and energy) have seen their prices tumble. The stage is set for a deflationary spiral. So why do professional forecasters put such low odds on a deflation scenario?

The Federal Reserve Bank of San Francisco, in a research note released today, concludes that forecasters are betting on aggressive central bank action. "Forecasters appear to be convinced that the Federal Reserve would not be content with sustained deflation and would take policy actions to restore a positive rate of inflation," writes John Williams, the San Francisco Fed's director of research. "This contrasts with the 1970s, when forecasters were concerned that the Fed would tolerate high rates of inflation."

Give the Fed a win (so far) for a successful communication policy on that front.
The Survey of Professional Forecasters puts the chance of core price deflation this year or next year at 1 in 20. The SPF sees core inflation (based on the price index for personal consumption expenditures, excluding energy and food) at 1.1% this year and 1.5% in 2010.

Mr. Williams dissects Phillips curve models of inflation and finds that one of them (based on the historical relationship between inflation and unemployment from 1961 to 2008) puts core PCE inflation at 0.3% in 2009 and a deflation rate of 0.8% in 2010.That puts the probability of deflation at 30% in 2009 and 85% in 2010.

The central bank can fight deflation by stemming slack in the economy and communicating its commitment to positive (but low) inflation rates, he writes. And the Fed is doing just that through its recent statements and its long-run inflation forecasts. "Such words, backed by appropriate actions, reinforce the anchoring of inflation expectations and reduce the chances of a deflationary spiral," Mr. Williams says.