How do we manage deflation?

The old bogeyman of deflation has re-emerged as a worry for the U.S. economy.

Here's something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works.
Deflation is usually associated with a Great Depression-like drop in demand.  Consumer prices, incomes and asset prices fall.  Interest rates go to zero, as low as they can go.  As prices and incomes fall, the cost to borrowers of servicing debt does not, sucking life out of the economy and pushing prices down further.  A bad situation, in short, gets worse.
In 1932, U.S. consumer prices fell 10% and between 1929 and 1933 they fell 27% in all.
But Japan's experience has looked nothing like this. Rather than being deep, destructive and concentrated in a few years, deflation has been a surprisingly mild, drawn-out affair. Consumer prices have been falling in Japan for 15 years, but never by more than 2% in any single year.  Japan's deflation has been a morass, but not the destructive downward spiral many economists predicted.  Why?  And what does it portend for the rest of the world today?
Economists don't have good answers.
"We don't know how deflation works," says Adam Posen, a member of the Bank of England's monetary policy committee who has been studying Japan since 1997. "We don't have a way of rationalizing steady, several-year flat deflation," he says.
This is a pressing issue for the U.S. Federal Reserve and other central banks.

Source: The Wall Street Journal, July 26, 2010

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2010, a Year of No Inflation

 September 13, 2010

By DAVID LEONHARDT

 

 

Bureau of Labor Statistics, via Haver Analytics Six-month change in the Consumer Price Index.

The lack of inflation this year is a story that deserves more attention than it has received.
On Friday, the Labor Department will release the inflation number for August. Economists are expecting an increase of about 0.2 to 0.3 percent over July’s Consumer Price Index. If that’s correct, it won’t be nearly enough to reverse a remarkable period in which prices have barely risen at all.
Over the last two years, inflation has been zero. Over the last year, it has been just 1.3 percent. Over the last six months, it has been below zero — negative 0.7 percent.
Since the Labor Department started keeping records in 1947, there have been only six six-month periods when prices have fallen more than that. All of them were in 1950, an unusual time when prices were falling even though the economy was growing.
This year’s price declines are clearly a reflection of the economy’s weakness. And yet the Federal Reserve has continued to
resist taking aggressive action to lift growth.
Remember, the Fed has a dual mission: keep inflation contained and maximize employment. By any measure, inflation is contained, and the economy is millions of job shy of maximum employment. Yet the Fed has taken only minor actions to lift growth and says it stands ready to take more action.
Why? The Fed — especially the regional Fed banks — is filled with economists and bankers who have strong memories of the 1970s and 1980s inflation. They’re always on guard against it.
There is no question that inflation can be terrible. Right now, though, it sure looks like the last war.

economix.blogs.nytimes.com