Today’s uber-cool CPI has got some fearing the attempt to reflate the economy is doomed, and they’d point to this chart and say we’re Japan 2.0.
But there is a counter, which is elucidated by Deutsche Bank:
We are not surprised by the relatively low readings on consumer inflation over the past few quarters, because inflation is a lagging indicator of economic activity. The lower-than-desirable growth rate on the consumer price index is largely a reflection of economic conditions during the height of the financial crisis. If economic growth accelerates above trend, pricing power among consumers should improve over the medium term to a rate more acceptable to monetary policymakers.
How real is the deflation threat? Inflation is a lagging indicator of economic activity. In general, price pressures are slow to react to changes in the pace of economic output growth. As the following figure demonstrates, inflation typically exhibits a six to eight quarter lag to economic output. In light of this relationship, it makes sense that core inflation has stalled-out to its current degree, because it is a lagged reaction to the sharp economic contraction which was occurring in the Q4 2008 to Q2 2009 period. Recall that in Q4 2008 real GDP was contracting at the fastest pace since the 1980 recession, and through Q2 2009 GDP was contracting for an unprecedented fourth consecutive quarter. It is important to highlight the several quarter lag between output and inflation for two main reasons in the current environment: First, in light of this lagged relationship, it is certainly possible for inflation to languish a while longer near the current levels, which monetary policymakers are finding uncomfortably low. However, the output recovery has remained intact for five consecutive quarters, and we expect the recovery to cross into expansion sometime in the current quarter or early 2011. Furthermore, we believe the likelihood of the recovery faltering is low. Hence, our second conclusion follows from the fact that growth has been positive for some time and is likely to remain so in the near-to-medium term. While the pace of output growth has fallen short of past recoveries, the relationship highlighted below still implies that in the relatively near term—probably one or two quarters—the underlying inflation trend should begin to stabilise. Ultimately, modestly above-trend growth will nudge core inflation higher
Here’s their chart: