We have deflation!

11/21/2013 01:35:00 PM
I got this in my inbox yesterday and should have posted it:
At an annualized rate, that's 1.2% deflation in October. Prices are falling.

A lot of Ron Paulites might celebrate what seems like good news--things are getting cheaper, they'll say. But they're wrong, because that's not how inflation and deflation work.  In reality, deflation does not make anything cheaper because while the prices of things you buy are falling, so too are the prices of things you sell (for example, your wage or salary), so that everything is just as expensive as before.

This news of deflation is troubling from a macro perspective, because deflation is contractionary (intuition: why would you spend now if you know prices will be lower in the near future?). Normally, this needn't be a huge problem because the federal reserve could just lower nominal interest rates to offset these short-run contractionary effects. However, presently nominal interest rates are already at zero, and can't go any lower under the current system. That means that right now, deflation is highly contractionary.

The BLS report does have a silver lining though, which is that core CPI--the price index of all items excluding food and energy--actually rose at an annualized 1.2% in October. Core CPI turns out to be a much better prediction of future price trends than the CPI index itself, so the way to interpret this is that the data is telling us that this deflation is a temporary blip that will soon reverse course. But there is still cause for concern here: those food and energy prices do still weigh on people's decision to spend now versus later, and moreover those food and energy prices are still someone's income here. And even looking only at core CPI, 1.2% annual inflation is way below the Fed's 2% official target, and even below the 0.5% tolerance window around that target that some Fed governors have hinted at. This is a clear signal for the need for more expansionary policy from the Fed.