Paul Krugman is worried we are Trending Toward Deflation.

Inflation has been falling, but how close are we to deflation? I found myself wondering that after observing John Makin’s combusting coiffure, his prediction that we might see deflation this year.



Here’s the thing: the usual way inflation is measured is by looking at the change from a year earlier. But if inflation is trending lower, that’s a lagging indicator — if prices have been falling for the past few months, but were rising before that, inflation over the past year will still be positive. On the other hand, monthly data are noisy. So what to do?



Well, a crude approach would be simply to fit a trend line through those noisy monthly numbers. Here’s what happens when you do this for the Cleveland Fed’s median consumer price inflation number. On the vertical axis is the monthly inflation at an annual rate, on the horizontal axis months with Jan. 2008=0:







...

What I take from this is that deflation isn’t some distant possibility — it’s already here by some measures, not far off by others. And of course there isn’t some magic boundary effect when you cross zero; falling inflation is raising real interest rates and making debt problems worse as we speak.

The Rising Threat of Deflation

U.S. year-over-year core inflation has dropped to 0.9 percent—its lowest level in forty-four years. The six-month annualized core consumer price index inflation level has dropped even closer to zero, at 0.4 percent. Europe’s year-over-year core inflation rate has fallen to 0.8 percent—the lowest level ever reported in the series that began in 1991. Heavily indebted Spain’s year-over-year core inflation rate is down to 0.1 percent. Ireland’s deflation rate is 2.7 percent. As commodity prices slip, inflation will become deflation globally in short order.



Meanwhile in Japan, while analysts were touting Japan’s first-quarter real growth rate of 5 percent, few bothered to notice that over the past year Japan’s gross domestic product (GDP) deflator had fallen 2.8 percent, reflecting an accelerating pace of deflation in a country where the price level has been falling every year since 2004. As of May, Japan’s year-over-year core deflation rate stood at 1.6 percent.

Consumer Prices Least of Bernanke's Worries

Devil is in the Definition

Practical Definition of Inflation and Deflation

Humpty Dumpty on Inflation

Falling Treasury Yields - Yes

Falling Home Prices - Yes, as measured by Case-Shiller



Rising Corporate Bond Yields - Not substantially - Yet. However sovereign credit spreads are widening

Rising Dollar - Yes

Falling Commodity Prices - Yes as measured by the $CRB from the beginning of 2010

Falling Consumer Prices - Yes (or at least close) as measured by the CPI. My preferred measure would directly include home prices and that would/will tip the CPI negative soon enough. I consider housing (but not the land it sits on) a consumer good.



Rising Unemployment - It is high and essentially steady. My model suggests no improvement at best, and far more likely new highs above 11%

Falling Stock Market - Yes as measured since the start of the year

Falling Credit Marked to Market - Yes, most assuredly

Spiking Base Money supply as Fed fights Deflation - This depends on your timeframe, but charts sure show a spike - Another spike is likely



Banks Hoarding Cash - Falling consumer loans - Declining bank credit - Yes, Yes, Yes



Rising Savings Rate - Yes. The US savings rate rose to an 8-month high in May



Purchasing power of gold rising - Yes

Rising numbers of bank failures - Yes

Bernanke's Deflation Prevention Scorecard

helicopter drop

Bernanke's Scorecard

Now What?

Would Flattening the Curve Help?

Consumer Credit Inflection Point

Keynesian Policies Fail

Keynesian Cures Worse than the Disease