Whatever Happened To Deflation?

The Bureau of labour Statistics reported that consumer prices rose 0.4 per cent in January. On closer inspection this should not be any big deal. Core inflation rose by just 0.2 per cent in the month. The main driver of the higher inflation was a big jump in energy prices. However even with this jump the overall CPI is only up by 1.6 per cent over the last year, a level that all but the most loony inflation hawks would consider acceptable.

Still, it is worth noting that the possibility of deflation seems to have disappeared from the scene. Since this possibility featured prominently in many discussions of the economy in the period immediately following the financial crisis, it probably would be worth some brief mention of its passing.

The issue of deflation has consistently been misrepresented in economic reporting. The economy is suffering from a lower than desired inflation rate, which limits the effectiveness of monetary policy. Given the severity of the downturn we would like a large negative real interest rate (e.g -0.6 per cent) . However, nominal interest rates cannot go below zero.

This means that the real interest rate can’t fall below the negative of the inflation rate (e.g, with a zero nominal interest rate, the real interest rate would be -1.0 per cent with a 1.0 per cent inflation rate and -2.0 per cent with a 2.0 per cent inflation rate). If the inflation rate falls below zero (i.e. we get deflation), this problem gets worse, but the drop in the inflation rate from 0.5 per cent to -0.5 per cent is no worse than the drop from 1.5 per cent to 0.5 per cent.

It was also predictable that there would not be persistent deflation in the United States. Wages are sticky downward, which made it unlikely that core prices would actually start falling. Also, the current rise in commodity prices was to be expected as the dollar would drift lower as a result of the U.S. trade deficit and also demand in China and other fast growing developing countries created scarcity for many products.

Anyhow, given how fears of deflation had once featured so prominently in discussions of economic policy it is worth some noting of their passing.

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