http://krugman.blogs.nytimes.com/2009/02/04/about-that-deflation-risk/
Paul Krugman - New York Times Blog
February 4, 2009, 4:42 pm
About that deflation risk
Look out below
<snip>
The figure above plots an estimate of the output gap -- the
difference between actual and potential GDP, as a percentage of
potential -- and the change in the inflation rate. Both series are
taken from the IMF WEO database, for convenience, and use data from
1980-2007.
It's not a perfect fit -- this is economics, not physics, and anyway
stuff besides the output gap bounces inflation around from year to
year. But still, there's a clear correlation (driven largely but not
entirely by the deep slump and disinflation of the early 1980s) and an
implied slope of about 0.5 -- that is, every percentage point by which
real GDP falls short of potential tends to reduce the inflation rate by
about half a point over the course of the year.
And right now the CBO is saying that in the absence of a policy action
the average output gap will average 6.8 percent over the next two
years. Do the math: if anything like the historical relationship
between output and inflation holds, we're looking at major deflation.
OK, maybe that relationship won't hold -- getting to actual deflation
may take a deeper slump than merely reducing the inflation rate. And
maybe a regression driven in part by 80s data isn't a good guide to
current events. But deflation is a huge risk -- and getting out of a
deflationary trap is very, very hard.
We truly are flirting with disaster.
<end blogpost>
Michael