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April 3, 2009

Economist's View - 7 new articles

Fed Watch: Johnson and Kwak vs. Bernanke

Tim Duy says that if the Fed is trying to raise inflationary expectations through quantitative easing, they are not doing a very good job:

Johnson and Kwak vs. Bernanke, by Tim Duy: Simon Johnson and James Kwak of the Baseline Scenario argue in today's Washington Post that the Fed risks triggering an inflationary spiral despite the current gaping output gap (see also Mark Thoma's comments here). I believe that Johnson and Kwak are perpetuating a misunderstanding about Federal Reserve Chairman Ben Bernanke's policy intentions, namely boosting inflation expectations. This is an understandable extension of the widely cited policy of quantitative easing. But despite the widespread use of the term quantitative easing, I still believe this is not Bernanke's understanding of the Fed's policy stance (see also David Altig). And, I would argue, if this is indeed the Fed's policy, Bernanke is doing a very bad job at implementation.

The key paragraph in Johnson and Kwak that I take issue with is:

Then in March, the Fed said that it will begin buying long-term Treasury bonds on the open market, hoping to push down long-term interest rates (by increasing the amount of money available for long-term lending) and thereby stimulate borrowing. The implication is that the Fed will finance these purchases by creating money. Not only that, but Bernanke wants us to know exactly what the Fed is doing; he hopes to push up our expectations of future inflation, so that wages and prices will nudge upwards, not downwards.

The implicit assumption is that the Fed is expanding the money supply via a policy of quantitative easing with the explicit goal of raising inflation expectations. First off, as Bernanke said once again today, he does not describe policy as quantitative easing:

In pursuing our strategy, which I have called "credit easing," we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.

Pay close attention to Bernanke's insistence that the Fed's liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment - a commitment to contract the money supply in the future. Is this any way to boost inflation expectations? See also Paul Krugman:

In that case monetary policy can't get you there: once the interest rate hits zero, people will just hoard any additional cash – we're in the liquidity trap. The only way to make monetary policy effective once you're in such a trap, at least in this framework, is to credibly commit to raising future as well as current money supplies.

If Bernanke really intends to raise inflation expectations, he is making an elementary error by reiterating his intention to shrink the Fed's balance sheet in the future. The current increase in money supply is thus transitory and should not affect future expectations of inflation. I can't see him making such an elementary error, which suggests that Bernanke's word should be taken at face value; he intends policy to be "credit easing," not the oft-cited "quantitative easing."

To be sure, the Fed is setting the stage for inflation if the price for their efforts to stabilize the financial system is monetary independence. The Fed is very, very aware of this risk; expect policymakers to keep reiterating Bernanke's intention to maintain independence. Note that he made this point in the quote above, and makes it again later in the same speech:

The FOMC will continue to closely monitor the level and projected expansion of bank reserves to ensure that--as noted in the joint Federal Reserve-Treasury statement--the Fed's efforts to improve the workings of credit markets do not interfere with the independent conduct of monetary policy in the pursuit of its dual mandate of ensuring maximum employment and price stability. As was also noted in the joint statement, to provide additional assurance on this score, the Federal Reserve and the Treasury have agreed to seek legislation to provide additional tools for managing bank reserves.

Johnson and Kwak also attempt to deal with the central criticism of inflation worries: How can inflation emerge given the gaping output gap? They solve this puzzle by analogizing the US to an emerging economy:

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of "slack;" there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

The challenge in my mind is that institutions in the US, primarily the relationship between management and labor, are not conducive to sustained inflation as they are in emerging markets. Desperation among workers is more likely to take hold. From today's Wall Street Journal:

Despite what objectives they may have put atop their resumes, when asked to describe the work they really wanted, the job seekers largely had the same goal: "I'll take anything right now."

In many cases, that desperation means that even educated workers must trade down to jobs below their potential and with lower pay. That results in painful, long-term effects, from hurting their own career advancement to displacing those with less education or experience.

Frankly ,I don't see a clear transition mechanism within the US economy to generate sustained inflation in this environment. I am somewhat more sympathetic to another threat Simon and Kwak identify:

We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared.

If the US Dollar cracked - a frequent fear of mine during the past year - and commodity prices surge, and the Fed effectively accommodated that price increase by easing policy further to counter the negative demand effect, which would effectively be a permanent increase in the money supply, then I can tell a story about an inflationary spiral. Such a story did not look ridiculous last year as oil was heading toward $150. Now, however, it is a lot harder to tell. Too many "ifs" and "maybes." A story that hangs together much better after a six-pack than my recent snack of sugar and caffeine.

Bottom line: I reiterate my concerns that the media and market participants are using the term "quantitative easing" too loosely. I understand that this complaint falls on largely deaf ears. If Bernanke is using quantitative easing to boost inflation expectations, then I think we need to seriously address the likely ineffectiveness of any such policy when Fed officials repeatedly promise to shrink the balance sheet in the future. In other words, they are explicitly committing to a temporary increase in the money supply. There is no reason to believe this will meaningfully impact inflation expectations. Such expectations, however, could be generated via a policy error. The error the Fed fears the most is they lose independence, the increase in money supply becomes permanent, and that political pressures force sustained increases in the money supply. Consequently, look for officials to consistently repeat their intentions to remain independent.

Is America repeating Japanese history?

Free Exchange looks at whether we are repeating the mistakes the Japanese made in dealing with their financial crisis, and finds worrying similarities:

Is America repeating Japanese history?, Free Exchange, The Economist: Early in his tenure, Tim Geithner, the treasury secretary, promised that American policymakers would not make the same mistakes Japan did in tackling its financial crisis. But as politics threaten to upend his efforts, Mr Geithner should take a second to consider why Japan made its mistakes.

Japanese officials took too long to commit substantial public money to recapitalising their banks. But it was not because they were ignorant of the dangers or Andrew Mellon acolytes hell-bent on liquidating speculators. Like Mr Geithner, they feared being shot down by voters and politicians furious that taxpayers might bail out overpaid bankers.

One Japanese official told me that when he sees Treasury officials testifying before congress with protesters waving anti-banker placards behind them, it reminds him of pictures in Tokyo newspapers in the 1990s. At the time, he and his colleagues knew that saving the financial system would require a lot of public money, but also felt it would be politically impossible to propose it until all other avenues had been tried.

This sentiment is eerily similar to what prevailed inside the Treasury in mid-2008. ... [...continue reading...]

Palley: "The Outlook for Macroeconomics and Macroeconomic Policy"

Heterodox economist Thomas Palley says:

I noticed that I posted Simon Johnson's "Quiet Coup" and Dani Rodrik's (mild) response. Here's an alternative hypothesis. The economics profession has been party to the capture of economic policy and government by the financial oligarchy. I hope you will consider discussing this alternative hypothesis on your blog.

Here's the preface to his paper, "After the Bust: The Outlook for Macroeconomics and Macroeconomic Policy," outlining his arguments:

Preface, by Dimitri B. Papadimitriou, January 2009: "Change" was the buzzword of the U.S. presidential campaign, in response to a political agenda precipitated by financial turmoil and a global economic crisis. According to Research Associate Thomas I. Palley, the neoliberal economic policy paradigm underlying the current agenda must itself change if there is to be a successful policy response to the crisis. He observes that the financial downturn has exposed the faulty economics of the existing policy paradigm, thus presenting the opportunity for real change, but that there are profound political, intellectual, and sociological obstacles to such change.

The ideology of the economics profession—mainstream economic theory—remains unreformed, says Palley, and he warns of a return to failed policies if a deep crisis is averted. Since Post Keynesians accurately predicted that the U.S. economy would implode from within, there is an opportunity for Post Keynesian economics to replace neoliberalism with a more successful approach.

Palley outlines the policy challenges, noting that there is significant disagreement among economic paradigms about how to ensure full employment and shared prosperity. A salient feature of the neoliberal economy, which is supported by mainstream economic theory (e.g., free trade, deregulation, and the notion of a natural rate of unemployment), is the disconnect between wages and productivity growth that explains widening income inequality. Workers are boxed in on all sides by globalization, labor market flexibility, concern with inflation rather than with full employment, and a belief in "small government" that has eroded economic rights and government services. Financialization, the economic foundation of neoliberalism, serves the interests of financial markets and top management. Thus, reversing the neoliberal paradigm requires a policy agenda that addresses financialization and ensures financial markets and corporations are more closely aligned with the greater public interest.

Palley outlines several major obstacles to changing both economics and economic policy. Social democratic political parties are divided in terms of the merits of the neoliberal economic paradigm.Other obstacles include the dominance of neoliberal economics within the academic community and among policymakers, which is supported by a misplaced belief that neoclassical economics is a scientific fact. This belief is used by the academic establishment to block alternative points of view.

New Keynesian economics is a form of real-business-cycle theory in the tradition of Arthur C. Pigou rather than John Maynard Keynes, says Palley. Though mainstream economists are willing to recommend Keynesian policies in times of economic crisis, they are unwilling to change the core analytical assumptions driving modern neoclassical macroeconomics (an example of so-called"cuckoo" economics).The only satisfactory escape from this intellectual and political stew is the creation of a new, progressive Keynesian consensus. That will require placing economics at the center of the political stage.

Inflation and the Fed

Simon Johnson and James Kwak argue that Ben Bernanke is "radically redefining his institution," and that his "willingness to pump money into the economy risks unleashing the most serious bout of U.S. inflation since the early 1980s, in a nation already battered by rising unemployment and negative growth."

This is, in essence, a question about whether inflation expectations are anchored or not, and that is also the key question is this discussion of the odds of deflation by John Williams of the SF Fed. He argues that the previous decades can be broken into a recent time period in which expectations appear to be well-anchored, the time period 1993 through 2008 is cited in the linked discussion, and a time period in the late 1960s and the 1970s when inflation expectations do not appear to be anchored (based upon Orphanides and Williams 2005). The paper also notes that recent surveys of professional forecasters are consistent with anchored expectations.

But past history shows us that expectations can move from one state to the other, from untethered to tethered, and there's no reason that cannot happen again, but in the other direction. So here I agree with Martin Wolf, it's dependent upon the credibility of policymakers. So long as people believe that the Fed is committed to preventing an outburst of inflation, and that they are capable of carrying through on that commitment, expectations will remain well-anchored. But if people believe that that Fed's hands are tied because of the harm reducing inflation would bring to the real economy, an out of control deficit, or due to political considerations that force them to accept inflation they could and would battle otherwise, then we have a different situation and long-run inflation expectations will change accordingly.

So there is nothing at all - except the credibility of the central bank - that guarantees expectations will remain anchored. I still believe that the Fed can and will prevent an inflation problem from developing, and I am not alone, but there are respected analysts who see it otherwise, or who are at least very worried, and that means the public can't be too far behind (the original is quite a bit longer, and explains the argument in more detail):

The Radicalization of Ben Bernanke, by Simon Johnson and James Kwak, Commentary, Washington Post: Timothy Geithner and his predecessor Henry Paulson have been the public faces of the U.S. government's battle against the global economic crisis. But even as the secretaries of the Treasury have garnered the headlines -- as well as popular anger surrounding bank bailouts and corporate bonuses -- another official has quickly amassed great influence by committing trillions of dollars to keep markets afloat, radically redefining his institution and taking on serious risks as he seeks to rescue the American economy. Without a doubt, this crisis is now Ben Bernanke's war.

Bernanke has become the country's economist in chief, the banker for the United States and perhaps the world, and has employed every weapon in the Federal Reserve's arsenal. He has overseen the broadest use of the Fed's powers since World War II, and the regulation proposals working their way through Congress seem likely to empower the institution even further. Although his actions may be justified under today's circumstances, Bernanke's willingness to pump money into the economy risks unleashing the most serious bout of U.S. inflation since the early 1980s, in a nation already battered by rising unemployment and negative growth.

If he succeeds in restarting growth while avoiding high inflation, Bernanke may well become the most revered economist in modern history. But for the moment, he is operating in uncharted territory. ...

In short, Bernanke is making the biggest bet placed by a U.S. central banker in decades, wagering that he can pull the economy out of a deep crisis by creating money without unleashing high and long-lasting inflation.

Will it work? In a normal advanced economy, creating hundreds of billions of dollars in new money would not foster runaway inflation. As long as the economy is underperforming ... stimulating the economy will only cause that "slack" to be taken up, the theory goes. Only when unemployment is low again can workers demand higher wages, forcing companies to raise prices.

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of "slack;" there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

If the United States is indeed behaving more like an emerging market, inflation is far easier to manufacture. People quickly become dubious of the value of money and shift into goods and foreign currencies more readily. Large budget deficits also directly raise inflation expectations. This would help Bernanke avoid deflation, but there is a great danger that unstable inflation expectations will become self-fulfilling. We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared. ...

Bernanke, the soft-spoken but authoritative academic, has redefined the Federal Reserve on the fly and exercised powers that Greenspan never dared touch. Bernanke's strategy is risky, and only time will determine whether he is being brave in averting a larger crisis, or reckless in unleashing inflation that could increase quickly and uncontrollably. Today, Bernanke's gamble looks like the worst possible alternative, apart from all the others.

Paul Krugman: China's Dollar Trap

It's time "to face up to new realities":

China's Dollar Trap, by Paul Krugman, Commentary, NY Times: ...The big news last week was a speech by Zhou Xiaochuan, the governor of China's central bank, calling for a new "super-sovereign reserve currency."

The paranoid wing of the Republican Party promptly warned of a dastardly plot to make America give up the dollar. But Mr. Zhou's speech was actually an admission of weakness. In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in into that trap in the first place.

Some background: In the early years of this decade, China began running large trade surpluses and also began attracting substantial inflows of foreign capital. If China had had a floating exchange rate — like, say, Canada — this would have led to a rise in the value of its currency, which, in turn, would have slowed the growth of China's exports.

But China chose instead to keep the value of the yuan in terms of the dollar more or less fixed. To do this, it had to buy up dollars as they came flooding in. As the years went by, those trade surpluses just kept growing — and so did China's hoard of foreign assets. ...

Aside from a late, ill-considered plunge into equities (at the very top of the market), the Chinese mainly accumulated very safe assets,... U.S. Treasury bills... T-bills are as safe from default as anything on the planet... But ... any future fall in the dollar would mean a big capital loss for China. Hence Mr. Zhou's proposal to move to a new reserve currency along the lines of the S.D.R.'s, or special drawing rights, in which the International Monetary Fund keeps its accounts. ...

S.D.R.'s aren't real money. They're accounting units whose value is set by a basket of dollars, euros, Japanese yen and British pounds. And there's nothing to keep China from diversifying its reserves away from the dollar, indeed from holding a reserve basket matching the composition of the S.D.R.'s — nothing, that is, except for the fact that China now owns so many dollars that it can't sell them off without driving the dollar down and triggering the very capital loss its leaders fear.

So what Mr. Zhou's proposal actually amounts to is a plea that someone rescue China from the consequences of its own investment mistakes. That's not going to happen.

And the call for some magical solution to the problem of China's excess of dollars suggests something else:... China's leaders haven't come to grips with the fact that the rules of the game have changed in a fundamental way.

Two years ago,... China could save much more than it invested and dispose of the excess savings in America. That world is gone.

Yet the day after his new-reserve-currency speech, Mr. Zhou gave another speech in which he seemed to assert that China's extremely high savings rate is immutable, a result of Confucianism, which values "anti-extravagance." Meanwhile, "it is not the right time" for the United States to save more. In other words, let's go on as we were.

That's also not going to happen.

The bottom line is that China hasn't yet faced up to the wrenching changes that will be needed to deal with this global crisis. The same could, of course, be said of the Japanese, the Europeans — and us.

And that failure to face up to new realities is the main reason that, despite some glimmers of good news — the G-20 summit accomplished more than I thought it would — this crisis probably still has years to run.

FRBSF: The Risk of Deflation

If you think inflation expectations are "unanchored," then you should be worried about deflation (Note: inflation forecast from the SF Fed's most recent economic outlook):

The Risk of Deflation, by John Williams, FRBSF Economic Letter: The worsening global recession has heightened concerns that the United States and other economies could enter a sustained period of deflation, as did Japan in the 1990s and the United States during the Great Depression. Indeed, a popular version of the well-known Phillips curve model of inflation predicts that we are on the cusp of a deflationary spiral in which prices will fall at ever-increasing rates over the next several years. A sizable and persistent deflation would likely worsen already very difficult global economic and financial problems. Macroeconomic forecasters, however, generally view such a dire outcome as highly unlikely. The most recent Survey of Professional Forecasters (SPF) puts only a 1-in-20 chance of core price deflation this year or in 2010. Are we on the brink of years of deflation, or are the professional forecasters right? This Economic Letter examines the risk of deflation in the United States by reviewing the evidence from past episodes of deflation and inflation.

The Phillips curve and the risk of a deflationary spiral

A useful framework for examining the behavior of inflation and the risk of deflation is provided by the Phillips curve model. This theory posits that the inflation rate depends positively on the expected rate of inflation and negatively on the degree of slack in the economy, as measured, for example, by the difference of the unemployment rate from its equilibrium level. For this discussion, it is useful to distinguish between two variants of the Phillips curve model that differ in how expectations are formed. In the first, "unanchored" Phillips curve model, expected inflation rates are assumed to depend primarily on past inflation rates. That is, people expect inflation in the future to be about what it was in the recent past, say the past year or two. In this case, inflation expectations are said to be "unanchored," in that they move around with actual inflation like a boat being pulled to and fro by the waves. As discussed below, this model does a good job of describing inflation in the United States for much of the postwar period and is therefore a popular model of inflation in the United States. If inflation expectations are unanchored, then a severe recession can lead to a deflationary spiral. The logic is as follows: In the early stage of recession, the emergence of slack causes the inflation rate to dip. The resulting lower inflation rate prompts people to reduce their future inflation expectations. Continued economic slack causes the inflation rate to fall still further. If the recession is severe and long enough, this process eventually will cause prices to fall and then spiral lower and lower, resulting in ever-faster deflation rates. The deflation rate stabilizes only when slack is eliminated. And inflation turns positive again only after a sustained period of tight labor markets. The second model is one where inflation expectations are "well anchored" in the sense that they are consistent with the goals and policies of the central bank. In this case, even in a severe recession, people expect the central bank to take policy actions that will restore a positive rate of inflation, and this expectation acts as a magnet pulling prices up. Although deflation will occur if the extent of slack is sufficiently large, a deflationary spiral only develops in the direst circumstances in which monetary policy is incapable of righting the economy (see Reifschneider and Williams 2000). These two versions of the Phillips curve model--one in which inflation expectations are well anchored and the other in which they are not--have very different implications for the likelihood, severity, and duration of deflation. In the end, which version better describes the behavior of inflation is an empirical question. To answer it, we turn to evidence from history. The Great Depression The natural starting point for a discussion of deflation is the U.S. Great Depression of the 1930s. The duration and magnitude of the declines in economic activity and prices during the Depression were astounding. Between 1929 and 1933, real gross domestic product per capita plummeted by nearly 30% and the unemployment rate soared from about 3% to over 25%. The consumer price index (CPI) plunged by nearly 25%, with the rate of deflation exceeding 10% in 1932. A striking pattern during the Depression and the decade leading up to it was a strong and stable negative relationship between the price level and the unemployment rate. As shown in Figure 1, the CPI and the unemployment rate were relatively stable during the 1920s. But, during the first four years of the Depression, the CPI plunged as the unemployment rate soared. That prices fell during the early part of the Depression is consistent with either version of the Phillips curve model of inflation. What is surprising is that the CPI then rose steadily from 1934 through 1937, despite the unemployment rate averaging over 18% during that period. Analysis of the relationship between prices and unemployment during the 1920s and the Depression indicates that the inflation rate was closely linked to the change in the unemployment rate, rather than the level of the unemployment rate. That is, when unemployment was rising, prices fell, and when unemployment was falling, prices rose. This finding indicates that inflation did not fall into a deflationary spiral as would be expected if inflation expectations were not well anchored. Instead, deflation lasted only while the economy was getting worse and turned to positive inflation once the unemployment rate stabilized. What explains this relationship between prices and unemployment? As discussed by Ball (2000), the behavior of inflation depends critically on monetary policy and the ways that policy affects inflation expectations. The United States was following the gold standard at the onset of the Depression, a policy that produces a relatively stable price level over long periods. After falling 25% in the early part of the Depression, prices were well below their "normal" level of the past. One interpretation of the outbreak of positive inflation between 1934 and 1937 was that people expected that prices would eventually rise again from abnormally low levels, and this expectation helped push the inflation rate into positive territory, despite the very high unemployment rate. Japan's lost decade Inflation dynamics today are likely to be very different than they were during the 1920s and 1930s. Among other reasons, the United States and other countries no longer adhere to the gold standard. Instead, they generally follow policies aimed at maintaining low, positive inflation rates rather than stable price levels. Japan provides recent evidence of what can cause sustained deflation. Core consumer price inflation in Japan averaged a little over 2% during the 1980s and the first half of the 1990s. Following the bursting of the Japanese housing and stock market bubbles, the economy tumbled into a lengthy recession, with the unemployment rate rising to nearly 5-1/2%, about three percentage points above its prior long-run average. Nine straight years of core CPI deflation followed, as shown in Figure 2. The anomalous spike in the inflation rate in 1997 resulted from an increase in the value-added tax that boosted consumer prices that year. Interestingly, despite the relatively high rates of unemployment in Japan during the past 10 years, a downward deflationary spiral did not ensue. Statistical analysis confirms that inflation in Japan is not described well by the unanchored Phillips curve model. Instead, inflation expectations appear to have been reasonably well anchored despite the prolonged period of deflation and high unemployment. The here and now The deflationary episodes in the United States during the Depression and more recently in Japan do not follow the pattern of a deflationary spiral predicted by the unanchored Phillips curve model (see Akerlof and Yellen (2006) for related evidence from other countries). We now turn to evidence from the United States during the postwar period. Unlike the two deflationary episodes described above, this model does a good job of describing the relationship between U.S. inflation and unemployment over the past 50 years. In the current recession, this model predicts that, with unemployment remaining very high, core inflation will fall steadily over this year and next, with deflation occurring in 2010. This forecast uses the most recent SPF unemployment projection and a Phillips curve model based on the historical relationship between inflation and unemployment from 1961 to 2008. The SPF forecast is for the unemployment rate to rise to 9% early next year and then edge down during the remainder of 2010. According to this model, the high degree of slack in labor markets pushes the core personal consumption expenditures price index (PCEPI) inflation rate down from 1.9% in 2008 to 0.3% in 2009, and down further to a deflation rate of 0.8% in 2010. Based on this forecast and the historical average of core PCE inflation forecast errors reported in Reifschneider and Tulip (2007), the estimated probability of deflation is about 30% for 2009 and 85% for 2010. This forecast is based on the "average" behavior of inflation over the past five decades, which includes both periods when inflation expectations were reasonably well anchored, such as the past two decades, as well as periods when they clearly were not, such as the late 1960s and the 1970s (see Orphanides and Williams 2005). As discussed by Williams (2006), the behavior of inflation over the past 15 years differs markedly from that in the preceding quarter century. A Phillips curve model estimate using data since 1993 is consistent with well-anchored inflation expectations and precludes the emergence of a deflationary spiral. Indeed, over the past 16 years, the U.S. inflation rate is negatively related to the change in the unemployment rate, rather than its level, similar to the pattern seen in the data from the 1920s and 1930s (see Gorodnichenko and Shapiro (2007) for related evidence). The forecast from this model, again using the SPF forecast for unemployment, shows core PCE price inflation slowing to 1.1% this year, but then rising to 1.6% in 2010. The estimated probability of deflation based on this forecast is about 3% in each year. This inflation forecast is nearly identical to the SPF forecast of 1.1 and 1.5% inflation in 2009 and 2010, respectively, and the estimated probability of deflation from the model forecast is roughly in line with those reported by SPF forecasters. Evidently, professional forecasters view the experience of the recent past as more relevant for forecasting than that from the more distant past. Forecasters appear to be convinced that the Federal Reserve would not be content with sustained deflation and would take policy actions to restore a positive rate of inflation. This contrasts with the 1970s, when forecasters were concerned that the Fed would tolerate high rates of inflation. This analysis highlights the central roles of economic slack and inflation expectations in the risk of deflation over the next several years. The evidence indicates that a substantial increase in slack can lead to deflation, but the depth and duration of the deflation depends on how well anchored inflation expectations are. Two policy implications can be drawn from this and other research on deflation. First, a central bank should take appropriate actions to stem the emergence of substantial slack in the economy and thereby reduce the risk of deflation. Second, it should clearly communicate its commitment to low positive rates of inflation. An example of such communication is the Federal Open Market Committee's recently released long-run inflation forecasts. Such words, backed by appropriate actions, reinforce the anchoring of inflation expectations and reduce the chances of a deflationary spiral. John C. Williams Executive Vice President and Director of Research

References Akerlof, George A., and Janet L. Yellen. 2006. "Stabilization Policy: A Reconsideration." Economic Inquiry 44(1) (January) pp. 1-22. Ball, Laurence. 2000. "Near-Rationality and Inflation in Two Monetary Regimes." NBER Working Paper 7988 (October). Gorodnichenko, Yuriy, and Matthew D. Shapiro. 2007. "Monetary Policy when Potential Output Is Uncertain: Understanding the Growth Gamble of the 1990s." Journal of Monetary Economics 54(4) (May) pp. 1,132-1,162. Orphanides, Athanasios, and John C. Williams. 2005. "The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations." Journal of Economic Dynamics and Control 29(11) (November) pp. 1,927-1,950. Reifschneider, David, and Peter Tulip. 2007. "Gauging the Uncertainty of the Economic Outlook from Historical Forecasting Errors." Board of Governors of the Federal Reserve, Finance and Economics Discussion Series 2007-60 (November). Reifschneider, David, and John C. Williams. 2000. "Three Lessons for Monetary Policy in a Low Inflation Era." Journal of Money, Credit, and Banking (November) pp. 936-966. Williams, John C. 2006. "Inflation Persistence in an Era of Well-Anchored Inflation Expectations." FRBSF Economic Letter 2006-27 (October 13).

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