Deflation or an unwelcome fall in inflation?

Bernanke has given some landmark speeches in his career as a Fed Governor and now Chairman. Though , much of his speeches are now testimonies on Economy and Financial Market Outlook. As a Governor, he had given some high quality speeches on an economic/finance issue. And the quality was so high that it could easily become a reference research paper on the topic.

In current times, his 2 speeches are worth reading. One on Deflation (21 Nov 2002) and other on sharp fall in inflation (23 July 2003; he titled his speech as An unwelcome fall in inflation).

The Deflation one has become part of economic folklore with most economists citing Bernanke’s speech to understand deflation and policy options to manage it. Infact, Mankiw points Bernanke is trying to walk his speech to avoid deflation in the economy. However, few think word deflation (read this superb Bin Smaghi speech on the topic) should be used carefully and it does not look like happening.

Whether deflation will happen or not would depend on a number of factors. However, what is certain is the sharp fall in inflation across economies(though in India CPI continues to rise). If this sharp fall in inflation starts getting reflected in inflation expectations as well (as in people start expecting prices to decline), then chances  of deflation become very high.

How do we analyse this fall in inflation? It is in this respect his second speech is quite useful. The speech actually explains the FOMC statement in May 6 2003:

Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.

Would Fed use similar words on inflation (as there are hardly any upside risks to growth) in upcoming FOMC meeting on Dec 15-16, 2008 as well? In its previous FOMC statement (Oct 29 2008) it says:

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

However, the recent numbers are anything but moderation in inflation. What we are instead seeing is a sharp fall in inflation which is clearly unwelcome. In the speech Bernanke says inflation outlook in medium term depends on  factors:

1. Economic slack
2. Inflation expectations.  
3. Supply shocks, such as changes in energy prices, food prices, or import prices. 
4. Inflation persistence.

Bernanke says out of the four, it is Economic Slack which is expected to be much higher and this would result in fall in inflation (disinflation).

The same can be applied in these times as well.Infact, in this crisis all the 4 factors are much worse than in 2001.  Hence, all 4 factors indicate that we are going to see sharp fall in inflation going ahead. However, as Fed has eased its mon policy substantially, whether it turns into a deflation is yet to be seen.