The fear of deflation has burst onto the radar screen of the financial markets in recent weeks. It showed up in the TIPS market in September, and it became more pervasive following last week's report on the October CPI, which featured a sharp drop in the index for all items and the first drop in the core index since 1982.
From a purely technical standpoint, it is easy to chart a path to deflation. Although a sustained drop in core price indexes is not likely in 2009, the rate at which the US economy is weakening suggests that price indexes could start falling as early as 2010 based on historical links between changes in core inflation and the jobless rate.
That said, we think there are a few lines of (imperfect) defense against the pernicious process that most people associate with deflation-a pattern of price decline broad-based and fast enough to foster expectations of more to come. Two such protections are (1) the wide dispersion of price changes across individual goods and services and (2) rigidities to nominal price and wage cuts.
The ultimate defense against deflation is policy activism, which US authorities are serving up in great quantity. Just this week, the Federal Reserve has committed to prove up to $800bn through various new programs and initiatives to support mortgage and consumer lending. While the main intent of these actions is to jumpstart lending and spending, an important element is to counter expectations of deflation by encouraging exactly the opposite.
These actions coupled with the incoming Obama administration's apparent determination to pass a sizable fiscal stimulus program make us more comfortable with the idea of gradual economic stabilization in 2009, despite the continued dismal economic data flow.