Deflation: Is it coming? Is it here? Has it come and gone?

John Makin recently warned that the US economy faced a risk of deflation.  Paul Krugman suggested that it might already be here.  I believe that outright deflation may have actually come and gone.  Nonetheless, I agree that sub-normal inflation will continue to delay the recovery, and support their calls for easier money.

A year ago I did a post discussing flaws in the way the US government computes price indices.  Official government statistics showed that housing prices were rising, even relative to other goods, between mid-2008 and mid-2009.   I hope I don’t need to explain how crazy that is—we were in the midst of the greatest housing price crash in American history (at least since record-keeping began.)   Because housing makes up 39% of the core inflation rate, it is quite possible that we actually experienced deflation in late 2008 and early 2009, even in the core rate.

The basic problem is that housing “prices” are based on imputed rents from out-of-date rental contracts signed while prices were still much higher, and which also ignore the frequent offers of one or two months rent-free on new contracts signed during the recession.  This is only slightly better than estimating housing costs on the basis of current monthly payments on 30 year mortgages taken out in 1981.

On implication of the flawed data is that the overall inflation rate was probably much lower than the official data showed during 2008-09.  Another implication is that at a later date these same sources will probably understate the actual rate of inflation.  I believe that has already begun to occur, and may explain part of the discrepancy between the two graphs in Krugman’s post.  As a result I think the second graph is more accurate—we now have low but slightly positive inflation.  Still, as Krugman argued in today’s column, we need much higher inflation if we are to have a robust recovery.

PS.  I was asked if I had ghostwritten Krugman’s most recent column.  All I am able to tell you is that thus far Paul Krugman has not authorized me to confirm or deny ghostwriting any of his columns.   Should I receive such authorization, I will let you know.

Seriously, he has made these points on some other occasions.  But I think he is certainly becoming more forceful on the subject of monetary policy, and other bloggers apparently share that perception.  In late 2008 I began this crusade amidst a widespread perception that the Fed had run out of ammunition.  I argued that it was fiscal policy that was out of bullets, that the $780 billion stimulus was probably all we would get.  I argued that monetary policy was our only hope.  I think it is fair to say that these views are now considerably more widespread than in late 2008 and early 2009.  I can’t say whether this blog has played any role in changing the intellectual climate on these issues, but at least I feel like I haven’t been wasting my time.  As I said in a recent post, “truth” is the view that gets accepted by my peers in the long run.  So my ideas are “truer” than 20 months ago.

PPS:  Makin and Krugman’s warning can also be interpreted as referring to the risk of deflationary expectations setting in.  That would be different from the transitory deflation of 2008-09.



21 Responses to “Deflation: Is it coming? Is it here? Has it come and gone?”

  1. Gravatar of marcus nunes marcus nunes
    12. July 2010 at 12:41

    It was nice to see Krugman returning to his “origins” after doing harm being partisan! (His op-ed at the NYT today is more detailed.
    But Bernanke does not let go of his “credit channel” fetish!

  2. Gravatar of marcus nunes marcus nunes
    12. July 2010 at 12:55

    It is impossible for Krugman to please!

  3. Gravatar of anon anon
    12. July 2010 at 13:09

    how often and how do they refresh the imputed rent calculation?

    i had assumed it was based on current (i.e. “new”) market rents

  4. Gravatar of Contemplationist Contemplationist
    12. July 2010 at 13:36


    I’ve been following your blog and the regular others (PK, MarginalRev, Delong, EconLog, etc) since the beginning of your blog continuously and obsessively. I think you are being way too modest. I know my observation could be biased but I think you are single-handedly responsible for the rise of monetary policy in the conversation within the last year. Of course by ‘responsible’ i do mean @ the source. Tyler Cowen helped boost you to the blogosphere and so he and others are ‘responsible’ in that way.
    Your constant hammering efforts at forcing the econ bloggers to re-learn modern monetary theory combined with the obvious realization that the damn fiscal stimulus was a farcical failure, and that we’re still wayy behind trend is responsible for the new-found maturity.

  5. Gravatar of Greg Ransom Greg Ransom
    12. July 2010 at 14:09

    “I believe that outright deflation may have actually come and gone.”

    So is the idea that we need to make up for a deflation years in the past with a new and equally large inflation?

    what if the deflation was 30 years in the past?

    Still re-inflate to “correct” things?

    What would make this not a great idea?

    Does microeconomics have anything to do with your answer?

  6. Gravatar of Benjamin Cole Benjamin Cole
    12. July 2010 at 14:41

    BTW, St. Louis Fed has published a piece on quantitative easing in their July letter.

    I agree with the sentiments of Contemplationist. The idea of QE is getting out there, and Sumner was present at the creation.

    Okay, here’s my contribution: I e-mailed a letter today to the Fed, advising them to aggressively go the QE route. Yes, a spitwad at the moon, but this is a democracy, and letter-writing is one of the few tools of regular folk. I won’t quote Eleanor Roosevelt about lighting a single candle…

    Finding out which Senators will approve pending Fed appointments (in Senate committee) might be worthwhile.

  7. Gravatar of Benjamin Cole Benjamin Cole
    12. July 2010 at 15:00

    On deflation–I think we are getting it right now. Unit labor costs have been going down, not up. Lower commercial rents (office, retail and industrial) are working their way through the system. I think right there we are at 60-70 percent of business costs. Steel and aluminum prices are going down.
    Phones are cheaper than ever, if you kill your landlines. Sending an e-mail is cheaper than postal. Is it my imagination, or is fast food cheaper than ever?
    Some say the CPI overstates, others say it understates. In any event, the CPI may reach a third straight down month, when June figs are reported.
    The worst thing is deflation in property markets–our banking system is not set up to endure real estate deflation. We have to reflate out of this mess.
    Better a long inflationary boom, than a long deflationary recession-depression.

  8. Gravatar of Doc Merlin Doc Merlin
    12. July 2010 at 16:21

    I really don’t know how it will work, deflation, inflation or what. Quantity theory will have to be tweaked now that the fed is paying for reserves directly.
    As the fed now pays interest on reserves, they can raise the rates we pay, without harming the banks. Because of this, AMB loses a lot of its connection to higher aggregates. So, I am unsure how it will go.

    However, if history is a guide, over any long enough period, we will have price inflation not price deflation.

    But if Kurtzweil and Robin Hanson are correct we are nearing the cusp of another singularity, and I should expect massive price deflation and RGDP growth.

  9. Gravatar of Benjamin Cole Benjamin Cole
    12. July 2010 at 16:22

    Dudes–check this out:

    “I consider the Fed’s policy rate–the federal funds rate–to be the dominant tool in the conduct of operations going forward. It is far and away the most powerful, its effects on the economy and financial markets most clearly understood, and it is the most effective in communicating our intentions.

    The Fed’s balance sheet of $2.3 trillion–of which $1.6 trillion represents long-term Treasury securities, agency mortgage-backed securities, and agency debt acquired since late 2008–should be considered, sized, and comprised independently of the policy rate. In my view, the macroeconomic effects of these extraordinary holdings are less significant, their effects on financial market conditions less clear, and the markets’ understanding of our objectives less understood than our dominant tool.

    Still, if federal fiscal policy is approaching its political or economic limits, some believe that the Federal Reserve should do more, including expansion of its balance sheet.”

    –The above from a speech given by FRB member Kevin Warsh, June 28, Atlanta Rotary Club. From the Fed website.

    I used to cover fnance in DC as a reporter. This sounds an awful lot like a “trial balloon.” In other words, Fed board members are testing waters, getting the public ready, a little underplaying what they are going to do, and emphasizing their conventional credentials and thought patterns.

    All good.

  10. Gravatar of Nick Rowe Nick Rowe
    12. July 2010 at 16:47

    It’s been very encouraging to start to see some sort of convergence of views recently.

    I think it’s important how deflation is defined. And the best definition of inflation is that which is most useful for the task at hand. In this case, that would be a measure of deflation that puts especial weight on the prices of newly-produced durable goods. Because it is the demand for those goods which is most influenced by real interest rates, and which matters most for aggregate demand.

    I did a post on this years ago:

  11. Gravatar of Indy Indy
    12. July 2010 at 17:06

    Housing is just sui generis this cycle – it’d probably be better to think about trends of inflation/deflation ex-housing this time around, until all the extraordinary government interventions wind down, and all the underwater mortgages clear and the market returns to some kind of normalcy.

    As an example of how far from normalcy we remain: back in May, CoreLogic released their negative-equity report with just enough tidbits of information that I was able to back-calculate the full distribution of mortgages in America using that least-squares (X’X)^(-1)X’Y matrix technique I learned in my Econometrics course. Here’s what those numbers say:

    Of the 47.7 Million mortgages they cover, 11.3 Million are underwater with a total of $820 Billion in Negative Equity. Compare the magnitude of that number with the total positive housing equity – $4,564 Billion (about 18%).

    Of those, 6.4 Million are slightly negative, with an average deficiency of $25K, but 4.9 Million are greatly negative (from 125% to 190% LTV), with an average deficiency of a whopping $135K (The bulk of these are in only four states: Nevada, Florida, Arizona, and California).

    Given this, and record rental vacancy rates, I expect the next three quarters to be slightly negative for housing, perhaps up to another 10% down in some pricey areas, relative to the trend overall price level. If housing continues to be included in inflation metrics, especially with its high weighting, those indexes will continue to understate what is happening in the rest of the economy.

  12. Gravatar of Morgan Warstler Morgan Warstler
    12. July 2010 at 17:40

    @Indy, lower rents mean more money to spend elsewhere. That is healthy and wise. The Fed shouldn’t even be holding these MBS, they would unwind them, and sell them off quick-as-split, otherwise they will continue to view real estate prices as something to consider in their machinations – something Scott admits they never should have concerned themselves with.

    They should treat the loss of MBS value as printed money put into the hands of low price auction winners… the guys with dry powder, who deserve their payday.

    With those assets off the Fed’s books, we can get to the bottom of which banks are insolvent and which aren’t.

  13. Gravatar of JeffreyY JeffreyY
    12. July 2010 at 21:57

    Another interesting thing about the recent convergence of opinion is that it seems to bear out what Scott was saying (and I was disagreeing with) last year. Now that fiscal stimulus seems impossible, the Fed is gearing up for actual monetary stimulus. If fiscal stimulus had been off the table from the beginning, would the Fed have paid attention sooner?

  14. Gravatar of Bonnie Bonnie
    13. July 2010 at 02:10

    I can’t really answer the question about deflation, but I can say that it looks like something that’s been and gone from data available on the BLS website. I found data that looks sort of strange if the economy really is as bad as has been discussed. Non-farm unit labor costs are up, productivity is up, and cash value of output is up. It looks good for here and now, but starting in 2005 they all look to be way above trend. Even the visible hiccup between 2Q 2008 and 1Q 2009 is above trend. Taking these kinds of numbers at face value, perhaps we’re looking at the glass being half empty?
    I’m a big history buff and I’ve been reading about the time period between the end of the Civil War and 1900. One of the books I have is The Tycoons by Charles R. Morris. It’s mainly about Carnegie, Rockefeller, Gould and Morgan, but he also discusses the depression of 1873 (pg.97-118). He refers to it as a supply shock. I don’t know how well accepted that point of view is, but with the above trend labor statics, I wouldn’t be so quick to rule out some kind of paradigm shift hanging out in the background that isn’t quite so obvious as going from an agrarian economy to industrialization, or typewriter to computers and the internet.
    I think it might have something to do with improvements in technology: mass consolidations of data, business processes, application services, and AI over fewer providers – from on-site to off-site vendor-provided cookie cutter stuff with customizations around the edges. It’s a second-wave tech evolution and I think it’s been happening since at least 2005 when “downsized” and “off -shoring” entered pop culture. It’s all about squeezing unnecessary labor out of the equation regardless of what kind. At first the IT revolution was a positive thing from an American labor point of view because the preference for on-site services meant hundreds of thousands of new well paying jobs. But now, times are changing and machines are doing more and more things that middle income folks used to do and they’re doing it far away from home as if in the next room.
    That leads me to my next point which is about Dr. Friedman. Monetary policy was only a slice of his work. He spent a lifetime on a crusade for more economic freedom and less government intervention in nearly all areas. My take on the sum of his theories is that sound monetary policy as only part of well functioning economy. When I read these discussions or others available for general consumption, it seems like the public policy piece is more or less the elephant in the room. It is probably the most nebulous and most difficult to identify exactly what about it is not working quite right, and can be quite controversial. But I think they are discussions that need to be had if we want to get people back to work. The Fed might be able to help with that, but I think there’s far more to the longer term than what it can deal with and we shouldn’t ignore it.

  15. Gravatar of scott sumner scott sumner
    13. July 2010 at 04:58

    marcus, Thanks. Even if Bernanke is right about small business, the effect is to lower the natural rate of interest—which means we need easier money.

    I plan to blog on Williamson eventually, but haven’t yet had time. I think he underestimates the problem of nominal instability.

    anon, Last time I checked (last year) they said it was based on existing contracts, not new contracts signed in the month of the survey (which is what it should be.)

    Contemplationist, Thanks for those comments. I should add that having to respond to commenters has helped me to refine my message—and I have learned a lot. Sometimes I fail to acknowledge people because I forgot who mentioned some fact or idea to me.

    Greg, No, I favor NGDP targeting, and I have suggested that we should not try to fully catchup to the old NGDP growth trend. If we are in the same boat 2 or 3 years from now, then we should let bygones be bygones regarding the CPI. But a catchup period does more than help us this time around, it helps stabilize the economy in the next recession by keeping inflation expectations higher than they would otherwise be.

    As the next recession begins we want a Fed promise to eventually return prices and NGDP to trend to be credible. It is more likely to be credible if we do it this time. The problem today is that the Fed won’t tell us what their target is.

    Benjamin, Yes, every letter counts.

    My hunch is that inflation is in the 0% to 1% positive range, but elsewhere I have argued that there really is no objective measure of inflation, even in a perfect information world. That’s because to get inflation numbers we must estimate how much better high tech machine Z is compared to previous high tech machine X. And that is partly subjective, as it gets into issues like “utility.” Either way, we could use easier money.

    Doc Merlin, I will leave the singularity forecasts to Robin Hanson!

    Benjamin, That Warsh statement seems a bit ambiguous. I hope your optimistic reading is correct.

    Nick, I get to the same place in a slightly different way. I view new home prices as more important that the rent on a 40 year old apartment building, because labor is used in building new homes, but labor is not used in providing the services from existing buildings. (Only capital is used.) Maybe that is a bogus argument, but it is my intuition on why falling house prices were more important than stable rental contract prices.

    And I agree that durable goods construction in general is a critical part of the business cycle. You might call durable asset construction “high powered output” (as an analogy to high powered money.)


    I’m out of time, I will get to the other comments later today.

  16. Gravatar of scott sumner scott sumner
    13. July 2010 at 07:35

    Indy, Why do those facts lead you to expect lower prices? Shouldn’t they already be incorporated into housing prices (assuming the EMH is true?)

    JeffreyY, Yes, this was needed in October 2008. We are already nearly 2 years too late. That is a long time in the context of business cycles.

    Bonnie, Regarding 1873, do you mean positive supply shock? I think some have claimed that rapid technological progress depressed prices in the late 1800s.

    I do think there are some supply side issues swirling around in the background, but I still think the sharp drop in NGDP between 2008-09 and 1873-74, is mostly demand side.

    I agree that Friedman was someone who contributed in all sorts of areas.

  17. Gravatar of Morgan Warstler Morgan Warstler
    13. July 2010 at 08:24

    Scott, IF you assume Indy’s data is correct, and we’re are going to stagger through another year of housing prices falling… THEN does it change your opinion on the Fed just hastening the decline.

    Why are you so opposed to guys with dry powder getting a sick payday in a brief brilliant turnover of glut?

    Do you actually know anyone with a couple million in the bank waiting for the day they get to buy up cheap houses? Do you know real estate investors who keep low balling banks and getting turned away… BECAUSE banks are hoping Scott will come riding to the rescue?

    Would you like to sit at a dinner table with them and explain, that you want to inflate away their rightful bargain basement discount buying spree?

  18. Gravatar of Jeff Jeff
    13. July 2010 at 09:09


    The main lenders to small businesses are regional banks that are not too-big-to-fail. These banks would have been the beneficiaries if the big banks had not been propped up, and even now their cost of capital is higher than the big banks because they don’t have the implicit government guarantee on all of their liabilities. So if Bernanke wants someone to blame for tight small business credit, he should start by looking in the mirror.

  19. Gravatar of Indy Indy
    13. July 2010 at 10:08


    “Indy, Why do those facts lead you to expect lower prices? Shouldn’t they already be incorporated into housing prices (assuming the EMH is true?)”

    That’s a good question that deserves a good response. Alas, wouldn’t you know it – bar exam’s in only two weeks!

    My eventual answer will have to explain why housing is simply a unique market, and why prices are sticky like wages, or why, since we don’t trade shares in houses like we do with stocks, the asset class doesn’t behave in a way that the EMH requires. Or that Keynes’ quote about “markets remaining irrational longer than you can remain solvent”:

    But in anticipation, I offer this admittedly anecdotal redfin listing:

    Check out that price history! A year of a kind of patient reverse auction process that has gradually knocked a third off the asking price from 2009 (when ‘the new market reality’) should have already dawned on everyone. Where will that knife finally fall?

    More to the point – why didn’t it fall there immediately? And why didn’t the housing indexes “correct” overnight, or even over a few quarters, vs. the slow multi-year wilting we’ve seen? Why don’t we see huge derivatives in the curce and volatility like in the stock market? The fact that we don’t may be an indication that the EMH is imperfectly applicable to housing.

    The story that house tells may be that people are so reluctant to let their houses go for anything but the highest price possible that they will sit and wait for months and years before adjusting their asks to clearing levels.

  20. Gravatar of Morgan Warstler Morgan Warstler
    13. July 2010 at 12:01

    There ya go Indy! Anecdotal? That’s everything!

    Now take that $340K house in 2001 and assume 2% inflation, and what are we looking at? $420K?

    Scott, life is so much easier if that house is worth $420K AS SOON AS POSSIBLE! And THUS, the Fed should liquidate rather than fight to delay the inevitable. Everyone deserves the coming clarity. The deserve to stop hoping price is going back up, before it keeps going down.

    We have a crisis in real estate. If the real estate guys with dry powder are not convinced prices have hit the bottom, let’s bend over and give them what they want. Forget credit, cash rules the day.

  21. Gravatar of scott sumner scott sumner
    14. July 2010 at 07:01

    Morgan and Indy, Look at that godawful ugly furniture in the third photo—no wonder the house didn’t sell!

    Didn’t US real estate prices level off in the second half of 2009 or early 2010? That doesn’t suggest sticky prices were holding up the real estate market, as if that were so the aggregate average should be falling.

    Also, the only true “price” is a sale price. The other prices listed don’t really mean anything other than that the seller was a fool.

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