Whose Afraid Of Deflation?

In my last post, William Gross said this:

"They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past."

Via Greg Mankiw, who wasn't convinced, came the following:

"In a previous post, I expressed surprise that yields on inflation-indexed Treasury notes are rising. Readers have emailed me a variety of hypotheses, the most common of which is deflation. As one smart economist put it:

Here's one possible answer -- the credit crunch has precipitated a massive expansion of money demand -- a scramble for cash. Despite its best efforts, the Fed has not matched this with a sufficient expansion of money supply. As simple IS-LM would predict, this surge in money demand has raised real interest rates (indicating that monetary policy is perhaps still too tight).

Rising real rates on inflation-indexed bonds and falling rates on nominal bonds also tell us that markets expect this surge in money demand to result in near-zero inflation or even deflation in the years ahead. It's starting to look more and more like 1990s Japan, though hopefully for not as long."

From Michael A. Fletcher's story today in the Washington Post:

"The confluence of trends has some economists worried that the country could be headed for a debilitating cycle of deflation: a period in which weak consumer demand, falling prices and tight credit ignite a downward spiral of still weaker demand and still lower prices. Under this scenario, as some businesses are strangled, joblessness increases, feeding the cycle.

"It was just a few months ago that everyone was obsessed with inflation. Now it's deflation," said Bill Gross, co-chief investment officer at Pimco, an investment management company. "I think it's a possibility."

And:

"Some economists note that a period of price adjustments does not necessarily signal the start of a deflationary spiral.

"Deflation is not the problem we should be worrying about," said Adam Lerrick, an economist at Carnegie Mellon University. "A drop in the level of prices for some goods must be distinguished from a continuous fall of prices. Oil is down to $90 from $140, but does anyone expect it will be $55 a year from now and $35 in 2010?"

Analysts said that a few months of price declines should not be a problem for the economy.

But if prices continue to fall across the board for a prolonged period, the declines will weigh heavily on businesses and consumers, particularly those juggling a lot of debt, which must be paid back even as money is harder to come by.

"For a few quarters, I say bring it on, but not for too much longer," Gross said of deflation. "Capitalism depends on mild inflation. Unless we get it, the dynamics of capitalism sort of move in reverse."

But then, there's this:

"In the United States, policymakers have been much quicker to respond to deflationary threats. Five years ago, as inflation approached 1 percent, spawning deflation concerns, Alan Greenspan, then the Federal Reserve chairman, cut the Fed's benchmark lending rate to 1 percent and the threat was never realized. It is an outcome that gives assurance to some economists.

"As long as governments print money and run deficits, you cannot have deflation," Lerrick said."

So, in the end, doesn't that mean inflation is the only real problem?