Is Deflation so Bad?

Via Timothy Taylor, the Bank of International Settlements (BIS) has a new report out on deflationary episodes.  Looking at the five years prior to an episode of deflation and at the five years after inflation, they do a kind of diff-in-diff estimator of whether the deflationary episode resulted in slower growth.  They find that, with the exception of asset price deflations, deflation alone does not lead to lower growth.

This is not that surprising to me.  When I first learned about deflationary spirals, I found the idea captivating, and it made a lot of intuitive sense.  However, upon reflecting on my own behavior, I realized that I do not behave the way the standard story goes.  For example, technology goods have famously gotten cheaper through the years, but I still line up to buy the latest edition, even though I know the same product will be cheaper in a year.

And it’s not just me.  Personal consumption expenditures on video, audio, photographic, and information processing equipment and media has not only steadily grown through the years, it has actually doubled as a percentage of total PCE since the 1960’s (from 1% to 2%).

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In an industry where there is consistent deflation, there has been massive growth.  This certainly seems consistent with the story told by the BIS.

Why Hasn’t There Been More Disinflation?

The Phillips curve, a relationship between the unemployment rate and inflation, has come under sharp criticism lately.  Contrary to what the Phillips curve would predict, the massive uptick in unemployment during the Great Recession has not resulted in much deflation.  Instead, inflation has mostly bounced between 1 and 2 percent over the past several years.

A possible contributing cause has been household expectations of inflation.  Although inflation since the beginning of the Great Recession has averaged around 1.5 percent per year, households have consistently predicted inflation to be 3 percent.  If the Phillips curve is augmented to include these expectations, then it explains that data very well.

But that just pushes the question one step further –  Why have people been consistently overestimating the inflation rate?  As we can see in the graph below, this positive bias is a relatively recent phenomenon, as the difference between the forecast and actual inflation tends to bounce around zero for the majority of the period 1978-2014.   Only recently (and for a couple of years in the mid-1990s) has inflation forecast been consistently upwardly biased.


A forthcoming paper by Coibon and Gorodnichenko explains this bias by showing that household inflation expectations have tracked oil prices quite closely.  They hypothesize that this is due to the undue influence gasoline prices play in the minds of consumers (it is the one price that virtually everyone that drives sees multiple times per day, and nightly news reports obsess over oil prices).

In contrast, Robert Waldmann has a post up today on Angry Bear which asserts that the reason for the higher inflation expectations has been due to the right-wing paranoia over high inflation.  He thinks that constant cries on Fox News that inflation has been too high (or will soon explode)  has led to the upwardly biased inflation expectations.