Probability of sustained deflation in US is just 5.3%

Jens Christensen of Federal Reserve Bank of San Francisco writes a timely paper on one of the several burning issues.

The recent economic slowdown has raised concerns about the possibility of sustained deflation in the years ahead. However, a refined model of inflation-indexed and non-indexed Treasury bond yields, which captures accurately the possible inflation outcomes perceived by bond investors, suggests that the probability of sustained deflation is just 5.3%. The model accounts accurately for the behavior of inflation-protected Treasury bond yields during the financial crisis and could prove reliable in evaluating deflation risk.

 In another paper Christopher Neely of St Louis Fed shows US has quite a few deflation episodes in history:

The vertical lines on the chart mark the approximate dates of the 1890, 1893, 1907, and early-1930s financial crises. These crises led to bank failures and a reduced money supply as depositors withdrew money, referring to hold cash. The severe contractions and deflationary episodes that followed these crises have shaped the U.S. perception of deflation. Inflation, output, and (as noted) the money supply fell during or shortly after each crisis.  The international experience has been similar; deflation  is often associated with poor output growth and high unemployment.

The recent decline in the U.S. inflation rate has been modest compared with past U.S. deflationary periods. Nevertheless, further declines in the inflation rate appear to be unwelcome by U.S. policymakers. The Federal Reserve is committed to maintaining price stability—consistent with its dual mandate—which observers often interpret as maintaining an average inflation target of 2 percent per year. 

History shows deflationary episodes are not so rare in US economic history. The current trends show not much probability as of now.

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