U.S. annual inflation slid deeper into negative territory in May as consumer prices posted their largest annual decline in almost 60 years

TO BE NOTED: From the WSJ:

"Consumer Prices Show Little Evidence of Inflation Threat

By BRIAN BLACKSTONE

WASHINGTON -- U.S. annual inflation slid deeper into negative territory in May as consumer prices posted their largest annual decline in almost 60 years.

Still, a slight rise from the prior month and an increase in core prices that exclude food and energy support the growing sentiment at the Federal Reserve that deflation risks have waned. However, there's little evidence that inflation is taking hold, either, a concern that has crept into bond markets in recent weeks.

The consumer price index rose 0.1% in May from April, the Labor Department said Wednesday, below economist expectations for a 0.3% increase in a Dow Jones Newswires survey.

The core CPI, which excludes food and energy prices, also rose 0.1%, in line with expectations.

Unrounded, the CPI rose 0.096% last month. The core CPI advanced 0.145% unrounded.

Consumer prices fell 1.3% compared to one year ago, the largest 12-month decline since April 1950. That's way below the 2% annual rate of inflation that most Fed officials think is consistent with their dual mandate of price stability and maximum employment.

Earlier this month, San Francisco Fed President Janet Yellen said that after once favoring 1.5% as an inflation objective, "I think if I now had to write down a number, I'd probably write 2%."

Annual inflation was above 5% as recently as last August, before last year's energy and commodity price drops kicked in and the global recession eased pressure on import prices.

But the annual CPI decline aside, Ms. Yellen and others at the Fed have little to worry about. Annual inflation rates should turn positive later this year given the recent rise in energy prices. And the less-volatile core CPI index was up 1.8% in May from one year ago, which is more in line with the Fed's objective.

"The recent data on inflation shows that the risks of deflation, which entered the minds of many central banks around the world over the last 18 months, the risks seem to be significantly attenuated," Fed Governor Kevin Warsh said Tuesday. Rather, inflation dynamics are "closer to a zone of price stability," he said.

According to Wednesday's CPI report, energy prices rose 0.2% in May from April, and were down 27.3% over the last 12 months. Gasoline prices rose 3.1% last month, while food prices slid 0.2%.

Transportation prices, meanwhile, increased 0.8%. Airline fares fell 1.5%, though new vehicle prices increased 0.5%.

Housing, which accounts for 40% of the CPI index, fell 0.1% for a third-straight month. Rent increased 0.1%, as did owners' equivalent rent. Household fuels and utilities prices slid 1.3%. Lodging away from home advanced 0.1%.

In a separate report, the Labor Department said the average weekly earnings of U.S. workers, adjusted for inflation, fell 0.3% in May, an indication that paychecks aren't keeping pace with prices, which could threaten consumer spending.

Current Account Deficit Shrinks

A broad measure of U.S. international transactions shrank in early 2009 because of the recession to its smallest level in seven years.

The U.S. current account deficit dropped to $101.5 billion during January through March, the Commerce Department said Wednesday. The deficit was the smallest since fourth-quarter 2001.

The $101.5 billion deficit exceeded economists' expectations for a deficit of $85.0 billion in the first quarter.

In the fourth quarter, the deficit stood at $154.9 billion, revised up from an originally reported $132.8 billion.

The current account balance combines trade of goods and services, transfer payments, and investment income.

The first-quarter shortfall of $101.5 billion made up 2.9% of gross domestic product, which was last reported at $14.090 trillion in current dollars for the three months ended March 31. That was the smallest share of GDP since 2.8% in first-quarter 1999. The record high was 6.6% at the end of 2005. The fourth-quarter 2008 current account gap of $154.9 billion represented 4.4% of a GDP of $14.200 trillion.

GDP is the broad measure of economic activity in the U.S.

Most of the current account balance is made up of trade in goods and services. A $91.2 billion first-quarter shortfall in goods and services trade was lower than the fourth-quarter's revised $144.5 billion. The fourth-quarter gap was initially estimated at $140.4 billion.

First-quarter imports fell to $373.4 billion from $469.4 billion. "All major and most sub-major commodity categories decreased," Commerce said.

Exports fell also. First-quarter sales dropped to $249.4 billion from $290.6 billion, with declines in chemicals, petroleum, capital goods, and cars.

While U.S. trade of goods was at a deficit, services trade was at a surplus. The surplus fell, though, to $32.8 billion from $34.3 billion in the fourth quarter.

Also contributing to the current-account deficit was a $29.6 billion shortfall in unilateral current transfers. Transfers are one-way payments from the U.S. to other countries and one-way payments from abroad into the U.S. The $29.6 billion shortfall is smaller than a $31.5 billion deficit in the fourth quarter.

Examples of current transfers include U.S. government grants, foreign aid, private remittances to workers' families abroad, and pension payments to foreign residents who once worked in a particular country.

Offsetting the overall current-account deficit was a $19.3 billion surplus of income, down from a $21.1 billion surplus in the fourth quarter.

The trade report showed that foreigners bought a net $56.9 billion of U.S. Treasury securities during the quarter, down from $81.5 billion of purchases in the prior three months.

Foreigners sold $15.5 billion worth of U.S. corporate bonds during the quarter, after net sales of $3.8 billion the previous quarter. They sold $45.3 billion of agency bonds, up from $21.4 billion in fourth-quarter sales.

Meanwhile, foreigners bought a net $6.0 billion of U.S. stocks, after selling $3.9 billion in the fourth quarter.

A Treasury Department report Monday said foreign and U.S. investors moved capital out of U.S. assets in April, the first month of the second quarter. The switch in capital flows reflect investors' greater appetite for risk. Net outflows in April, including short-term securities and changes in bank deposits, totaled $53.2 billion, according to the Treasurys International Capital report, compared with the inflows of $25 billion in March.

Wednesday's Commerce Department data said foreign direct investment in the U.S. increased $35.3 billion, after rising $96.8 billion in the fourth quarter. "The slowdown was more than accounted for by a slowdown in net equity capital investment in the United States and, to a much lesser extent, a shift from positive to negative reinvested earnings," Commerce said. .

—Jeff Bater contributed to this article.

Write to Brian Blackstone at brian.blackstone@dowjones.com"

inflation has disappeared and we are wondering if and when it will come back

TO BE NOTED: From Supply and Demand (in that order):

"Inflation, We Need You

When his mom would leave the house shopping for a few hours, my toddler son used to go the window and yell out "Mommy, I need you!"

That's pretty much where our economy is right now: inflation has disappeared and we are wondering if and when it will come back. This morning the BLS released the April CPI, which (seasonally adjusted) was lower than March. The seasonally adjusted CPI has fallen month-to-month five out of the last seven months.

The chart below shows the seasonally adjusted CPI (blue) for 2008-9 and the seasonally unadjusted CPI (red) for the 1929-30 (sorry, no seasonal adjustment is available for 1929-30).

Posted by Casey B. Mulligan "

could prove to be a significant limiting factor on how much the Fed can hope to achieve from monetary stimulus

TO BE NOTED: From Econbrowser:

"Inflation and relative prices

There are persuasive reasons why we'd be better off today with an inflation rate higher than what we've seen over the last six months. But while a uniform expansion that raised all wages and prices by the same amount would be helpful, what the Fed could actually achieve in the present situation may be something less desirable.

When academic economists talk about inflation, we often think in terms of a single-good economy in which the concept refers unambiguously to an increase in the dollar price of that good. But in the real world, in any given month some prices rise and others fall, and we can only measure inflation in terms of the broad central tendency behind those individual price changes.

A recent research paper by Columbia Professor Ricardo Reis and Princeton Professor Mark Watson suggests that real-world measured inflation may behave very little like the textbook ideal. Reis and Watson introduce the hypothetical concept of a pure inflation shock as something that changes every price by x(t) percent, where in any given quarter t the magnitude x(t) is the same number for every item in the economy. Reis and Watson show how such a shock can be measured for any given quarter by observing the behavior of separate components of the PCE deflator. Their principal finding is that this concept of pure inflation in fact plays very little role in quarterly changes in broad price indexes such as the GDP deflator or the consumer price index, accounting for only 15-20% of measured inflation. The authors instead find that changes in relative prices are much more important than pure inflation for determining what happens to the broad CPI. For example, the measured deflation over the last 6 months is heavily influenced by falling energy prices.

If you think that the Federal Reserve is responsible for more than 15-20% of the variation in the CPI, the implication is that part of its influence comes from changes it causes in relative prices. But changes in relative prices-- such as the huge run-up in energy prices in the first half of 2008-- can be much more destabilizing than the textbook pure inflation.

I would therefore think that the Fed might be somewhat concerned by the surge in commodity prices over the last few weeks. The graph below plots the prices of 11 commodities since the Fed's announcement of quantitative targets on March 18. Gold is the only one of these commodities that hasn't gone up in price, with the average of these commodities up 13% over the last two months.

Prices of assorted commodities normalized at March 17, 2009 = 100. Data source: WSJ commodity cash prices, via Webstract.

Some increase in relative commodity prices is certainly to be expected if we are indeed about to see a recovery in real economic activity. But this is a trend the Fed needs to watch closely from here, and could prove to be a significant limiting factor on how much the Fed can hope to achieve from monetary stimulus.

Because I for one do not think it's a good idea to call for a replay of the 2008:H1 commodity market show.

---

Technorati Tags: macroeconomics, commodity prices, economics, Federal Reserve, deflation, inflation

Posted by James Hamilton"

the only area that saw price declines year over year was transportation, dropping 12.5% year over year

TO BE NOTED: From EconomPic Data:

"CPI Down; Solely Due to Transportation

BLS details:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2 percent in March, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The index has decreased 0.4 percent over the last year, the first 12 month decline since August 1955.

Looking at the chart below, we see the only area that saw price declines year over year was transportation, dropping 12.5% year over year.



This 12.5% had a weighted impact on CPI of -2%, thus CPI "ex transportation" was at 1.6% year over year. Remarkably, the change in the price of gasoline itself had an impact of -1.2% of that -2%.

Source: BLS

Posted by Jake at 5:40 AM

As shown, the current level of -1.95% represents a 59-year low.

TO BE NOTED: From Bespoke:

"CPI and PPI Both Showing Deflation

This morning's CPI report showed that consumer prices declined by 0.4% versus their levels a year ago. It also confirmed the deflationary trends in yesterday's PPI report, which showed a 3.5% year/year decline in producer prices. Negative prints in the CPI or PPI are rare enough, but for both to be negative in the same month is even more unlikely. Since 1948, there have only been 20 other months out of 734 where both indices were negative on a year/year basis. The last time we saw this occur was back in July 1955. In the chart below, we show the historical average reading of the year/year PPI and CPI. As shown, the current level of -1.95% represents a 59-year low.

While statistics like these cause most people to consider inflation the least of our worries, things have a way of changing fast. As recently as seven months ago (August 2008), the average inflation gauge was rising at the fastest rate since December 1981.

April 15, 2009 at 10:37 AM in Economy | Permalink"

30% of CPI was showing a pretty hefty increase when, in reality, rents and home prices were falling dramatically

TO BE NOTED: From Don Fishback’s Market Update:

"Evidence: CPI Understates Deflation

In this L.A. Times article, they note that rents in L.A. County fell 4%. They also point out that rents in Orange County and in the Inland Empire also fell. At the other end of the spectrum, the Bureau of Labor Statistics database shows that rent in this area of the country went UP +3.8% during the same time frame.

This article provides anecdotal evidence that rents in New York are headed lower, with some landlords offering rent discounts just to keep tenants from leaving. That sure doesn’t jibe with the BLS data that shows the cost of renting a New York area apartment going UP the first two months of this year.

And it’s not just geographically isolated. According to this article, national rents fell 1.1% in the last quarter. BLS data, on the other hand, has rents RISING the first two months of the year (March data will be released next week).

While rent makes up about 6% of the CPI, rent has another consequence with a far greater impact. Remember, BLS doesn’t use actual housing price data to calculate the cost of a owning or purchasing a house. It uses “Owners’ Equivalent Rent”, which is based on rent. For instance, in the same BLS database that showed LA-area rents going up +3.8% in 2008, BLS showed LA-area home prices going up +3.3%. And OER has a 24% weighting in CPI, which means that a full 30% of CPI was showing a pretty hefty increase when, in reality, rents and home prices were falling dramatically.

– Don

See: Update on House Price Inflation, Is Deflation Understated by CPI?"

Fears Britain might enter a deflationary spiral receded on Tuesday after inflation rose in defiance of expectations last month.

TO BE NOTED: From Datablog:

"UK inflation - now it's deflation

Comments (0)

Time was we were all worried about soaring inflation. Nowadays it's more likely to be the opposite: deflation.

The latest figures make grim reading:

The annual RPI rate - the country's broadest measure of inflation - fell to 0% in February after recording 0.1% the month before, according to figures from the Office for National Statistics. Today's was the weakest reading since 1960.

The measure which causes that concern is inflation, but there are different ways of measuring . It used to be by the Retail Price Index, which rates the change in the cost of a fixed basket of retail goods.

But the government prefers the Consumer Price Index, which also includes services, housing, electricity, food, and transportation. The figures are collected and published each month by the Office for National Statistics.

DATA: UK inflation since the 1940s - CPI and RPI
INTERACTIVE: how we visualised the data"

And then:

Inflation surprises with jump to 3.2%

By Daniel Pimlott, Economics Reporter

Published: March 24 2009 10:13 | Last updated: March 24 2009 22:01

Fears Britain might enter a deflationary spiral receded on Tuesday after inflation rose in defiance of expectations last month.

As the sharp fall in the value of the pound fed through in the form of higher prices for shoppers, the consumer price index increased from 3 per cent in January to 3.2 per cent in the year to February, confounding economists’ forecasts of a further fall to 2.6 per cent. Inflation has fallen from a peak of 5.2 per cent in September.

The rise in inflation forced Mervyn King, the governor of the Bank of England, to write to Alistair Darling, the chancellor, to explain why prices were still rising more than one percentage point above the Bank’s 2 per cent target.

The data appear embarrassing for the Bank. It has cut interest rates to the lowest level in its 315-year history and begun an unprecedented programme to create money and to buy assets.

But Mr King said the rise in inflation reflected retailers’ decisions to pass on the fall in sterling to consumers – although he was optimistic about the medium-term implications. “Even if we see significant pass-through of the depreciation of sterling, it may mean inflation is close to the target rather than below it. I don’t see a large risk of inflation being significantly above it,” the governor told the Treasury committee on Tuesday.

The effect of higher import prices – reflecting sterling’s near-28 per cent drop in value since the summer of 2007 – seemed to be evident in some categories that made the biggest contribution to the inflation rate.

Life becomes cheaper for many richer families

The poorest and oldest people in society are experiencing much higher rates of inflation than other citizens, writes Chris Giles.

The items with the largest falls in price in Tuesday’s figures – mortgage interest payments and petrol prices – matter much more to the rich than the poor. Consequently, life is getting cheaper for most richer families, according to research by the Institute for Fiscal Studies. Food prices, by contrast, are up by 11.3 per cent over the past year, while electricity and gas for cooking, light and heating are up 22.3 per cent. So poor and elderly people, for whom these are big budget items, are much harder hit than the headline inflation rate would suggest.

The Office for National Statistics calculates the retail and the consumer price indices by monitoring thousands of price changes and weighting the results by the amount the nation spends on each item. The rich spend a lot more than the poor, giving the wealthy a much bigger weighting in the overall RPI or CPI than a household with average income.

This is not usually an issue because price changes are similar across goods and services consumed disproportionately by the rich and poor. “The differences tend to even out over time – it is not true to say the poor always do worse [on inflation],” says Zoë Oldfield, of the IFS.

But this is not the case at present, with price rises on the essentials of life far outstripping those on relative luxuries. As a result, there are huge differences in the inflation rates experienced by households of different ages, incomes and housing tenure.

If you average all households’ inflation rates, you get 1.6 per cent, the IFS says – significantly higher than the zero RPI inflation which is the average for all expenditure.

But analysis of household inflation by the IFS also reveals that, as in so many things in life, the rich count for more than the poor when it comes to the cost of living.

Continued sharp rises in food prices were responsible for faster-than-expected increases overall. Food inflation stood at 12.5 per cent in February, compared with 11.1 per cent in January. Within that, prices for fresh vegetables were up by 18.6 per cent, partly due to cucumbers and courgette prices rising after a poor Spanish harvest.

The cost of meat was up by 15.2 per cent. A spokesman for the British Retail Consortium said farmers were increasingly exporting meat rather than selling it in the UK because of higher prices offered abroad.

Other categories where figures showed a marked rise in inflation were games, toys and hobbies, transport costs, household appliances and clothing and footwear.

Games and toys showed a 2.5 per cent increase in prices during the month, while on an annual basis they were down by 0.1 per cent after falling by 6.4 per cent in December. Toy imports make up 85 to 90 per cent of all toys sold in the UK, according to David Ackerman, chairman of Equitoy, a trade association of toy importers.

The ONS added the rise in inflation also reflected companies increasingly deciding to reverse the value added tax cut implemented in the pre-Budget report last year. Some companies said they were reinstating prices that had prevailed before the VAT cut, as it was company policy to do so, but most said the decision reflected higher import prices, according to an ONS statistician.

Continued strength of inflation despite deepening recession made it increasingly unlikely the UK would face a prolonged period of deflation, economists said.

The broader retail price index fell to a 49-year low in February of 0 per cent. Economists had expected it to plunge to -0.7 per cent. However, that reflected sharp falls in housing costs and energy prices for households, rather than big changes in retail costs.

Longer term, an array of forces will bear down heavily on prices. Falling fuel costs will erode headline inflation.

Rising unemployment and increasingly weak international trade will also open up a gap between the capacity of the economy and level of demand, driving prices lower. As the effect of sterling’s decline disappears from the index, inflation will also fall.

“Aggregate demand is falling away rapidly,” said Ben Broadbent, an economist at Goldman Sachs. “Regardless of the exchange rate, it’s reasonable to say inflation will fall away next year.”

Economists expect that while the RPI will fall for an extended period of time – thanks to the fall in mortgage interest costs – the CPI will turn negative only briefly this autumn.

Will deflation – the concept dreaded by economists and politicians alike – at least briefly stalk the land? No, says George Buckley, an economist at Deutsche Bank. For that to happen “a sustained decline in the price of goods and services” would be required. The risk of that had now diminished.

Copyright The Financial Times Limited 2009

The CPI and PPI both increased in February, for the second month in a row.

TO BE NOTED: From Supply And Demand:

"Deflation May be Done

The CPI and PPI both increased in February, for the second month in a row.

That may break a pattern that, prior to February, was all too similar to 1929-30. The chart below displays the (seasonally unadjusted) CPI for 2008-9 and 1929-30.

Posted by Casey B. Mulligan at 5:50 AM

"Perhaps the bubbles in asset prices that were suppressed would only pop up somewhere else"

Nick Rowe weighs in with an idea I just tossed in the bin:

"The Bank of Canada should peg the TSE 300" - revisited

"The Bank of Canada should peg the TSE-300" is the title of a Carleton Economics Department working paper I wrote in 1992. (Sorry, but no web version available; this was in the olden days when all we had was paper, and when the TSX was the TSE.) Given the recent turmoil in financial markets, and the renewed interest in having central banks look at asset prices, I was wondering whether to resurrect this paper, but dithered. Now Roger Farmer has beaten me to it. Mark Thoma posted it on his blog, and Tyler Cowen on his.

The reactions in the comments are mostly either unfavourable, or incredulous. I thought I would write a few words in defence of the idea, and then say why I no longer support it( THANK GOD ).

Many critics are just confused, and think that using monetary policy to peg an index of stock prices is some sort of interventionist policy that prevents markets finding their own equilibrium. But if governments produce money, and they do, then governments have to decide how much money to produce. They have to target something( TRUE ). That something can be the price of gold, or silver, or the exchange rate with another government's money, or the CPI (as in inflation targeting). Or it can be an index of stock prices. In principle, any nominal (measured in dollars) variable can be the target for monetary policy, and the TSX 300 is a nominal variable.

Pegging the TSX 300 is no more interventionist( OK. BUT WHAT IS THE TARGETING FOR? ) than pegging the price of gold, or pegging the CPI (as we do now with inflation targeting). In the long run( BUT CAN IT EFFECT THE SHORT RUN? ), market forces determine the real (inflation-adjusted) value of the TSX 300 even if the Bank of Canada pegs the nominal value; the same is true if the Bank of Canada pegs the price of gold. If this bothers you, just think of the Bank of Canada pegging the value of the Canadian dollar to the TSX 300, rather than vice-versa.

Let me be more precise. My 1992 proposal was that the Bank of Canada should peg the time-path of the total return index of the TSX 300, so it would grow at some fixed rate of (say) 7% per year. The total return index is a better target then the index itself, because it is immune to arbitrary changes in firms' dividend payout ratios.

There is one very curious effect of pegging the total return index to grow at (say) 7% per year. It would mean that a stock index fund would be as safe an investment as Canada Savings Bonds are now, since the holder would be certain of the nominal interest rate (but the real interest rate would be uncertain in both cases). It would be hard to imagine that the equity premium could persist, which could be an important advantage of the policy. All nominal interest rates on government bonds and other safe assets would have to pay the same 7% per year. The TSX 300 would be an ideal investment for widows and orphans.

The main rationale for the policy would be the hope( OK ) that it would tame financial bubbles and crises. Also, if stock prices predict the business cycle, and if this correlation implies causation, taming stock prices might also tame the business cycle.( IT'S A REGULATOR )

It seemed to me a good idea in 1992, but this was before inflation targeting really got off the ground, so I didn't have much to compare it to. A few years ago, when inflation targeting seemed to be performing very well, I changed my mind, and decided it was "very interesting....but stupid". Now I am just uncertain. Here are the main problems.

First, stock prices are very flexible, but a lot of goods prices are very sticky. There is a long-standing principle in macroeconomics that business cyles are caused by sticky prices, and the best macroeconomic policy is to make sure that the prices which don't change quickly don't have to change quickly( A GOOD POINT ). This principle suggests we should target an index of sticky prices (or wages), and the CPI comes a lot closer to this than the TSX 300.

Second, the real fundamental equilibrium value of the TSX 300 can change by a large amount very quickly, due to fundamental changes in profitability, the growth rate of profits, or real discount rates. But if the nominal value of the TSX 300 were pegged, the only way the real value of the TSX 300 could reach its new equilibrium would be for the CPI to adjust. Big fluctuations in the CPI would be undesirable if they did occur, and even more undesirable if they needed to occur but couldn't, because goods prices are sticky. For example, a cut in corporate taxes which would cause a (say) 20% rise in stock prices when the Bank targets the CPI would instead have to cause a 20% decline in the CPI if the Bank targets stock prices.

Finally, the stock market is perhaps a barometer of the state of the economy, but we cannot be sure that pegging the barometer would stabilise the weather. Goodhart's law...(((

Although Goodhart's law has been expressed in a variety of formulations, the essence of the law is that once a social or economic indicator or other surrogate measure is made a target for the purpose of conducting social or economic policy, then it will lose the information content that would qualify it to play such a role. The law was named for its developer, Charles Goodhart (a chief economic advisor to the Bank of England).

The law was first stated in a 1975 paper by Goodhart and gained popularity in the context of the attempt by the United Kingdom government of Margaret Thatcher to conduct monetary policy on the basis of targets for broad and narrow money, but the idea is considerably older. It is implicit in the economic idea of rational expectations. While it originated in the context of market responses the Law has profound implications for the selection of high-level targets in organisations^[1].

It has been asserted that the stability of the economic recovery that took place in the United Kingdom under John Major's government from late 1992 onwards was a result of Reverse Goodhart's Law: that, if a government's economic credibility is sufficiently damaged, then its targets are seen as irrelevant and the economic indicators regain their reliability as a guide to policy)))

...suggests the opposite. Perhaps the bubbles in asset prices that were suppressed would only pop up somewhere else. Indeed, the classical dichotomy suggests that they would pop up somewhere else( YES ); positive asset price bubbles would pop us as negative CPI bubbles.

I'm not prepared to rule out targeting some weighted average of goods prices and asset prices. But even a broad index of stock prices is a narrow representation of even financial assets, let alone land, houses, and human capital."

I don't like Mechanical Interventions, which this is. It's, in effect, a regulator. I simply don't buy it any more than using interest rates to stop bubbles. It's too blunt an instrument, and I don't believe that it addresses the insurance needed to prevent calling runs. In other words, if it doesn't work, the illusion of safety will lead to another ghastly blowup. By the way, any regulator must be set, which is another reason I don't like it. Economists don't qualify as engineers.

There must be a hundred ways people believe that we can prevent bubbles, and, if we have a Treasury Bubble now which bursts, they won't even be noticing one right in front of their faces. Bagehot's Principles are the ticket. Stop printing up false ones.

"However, after the bubble, which peaked in 2005-06, expect a severe over-correction to the downside."

From EconomPic Data, another look as the Home Prices data:

"Case-Shiller Price Index (October)

For more information on what the Case Shiller Price Index is and why it may be an important measure, check out this old post.

The Case-Shiller Price Index (an adjustment to CPI) turned severly negative year over year, down 1.4% from last October as home prices, a global slowdown, and the reversal in energy prices severely impacted price levels.

Looking at the five year change in the Case-Shiller Index (the housing index, not the self created price index), we see home prices reverting back to a more "normal" 2% annualized level. However, after the bubble, which peaked in 2005-06, expect a severe over-correction to the downside.

Source: BLS / S&P"

The overshoot might explain why the Mayer/Hubbard figures for a bottom to the decline in housing prices might not work.

"However, might real GDP actually grow Q3-Q4?"

Casey Mulligan with another bold prediction:

"I think that the forecasts of real GDP growth rates Q3-Q4 of -5 to -6 percent (annualized) are too pessimistic. However, might real GDP actually grow Q3-Q4?

PRODUCTIVITY ANGLE

We have employment and hours numbers for Oct and Nov already saying that aggregate labor hours growth Q3-Q4 (annualized) will be -7 to -8 percent. That means that real GDP growth requires total factor productivity (this is different from hourly productivity I have discussed in previous posts -- TFP is how much GDP would grow if labor were constant) to increase 5 percent or more. That's more than the trend productivity in the recent past, so the odds must be less than 50%.

Productivity growth (for one quarter, at annual rates) has been 5% or more during previous recoveries. It happened two quarters in a row starting 6 quarters after the start of the 1981-82 recession. It happened 4 quarters after the start of the 1990 recession, and again 3 quarters later. It happened 3 times in the year following the start of the 2001 recession. Interestingly, the 2001 recession was a recession with very little quarter-to-quarter productivity decline (this recession has none). This tells me that the odds are not negligible.

Also note that there was a major hurricane and a strike in Q3, which were gone by Q4. This by itself would create a bit of productivity growth.

PERSONAL INCOME ANGLE

I am confident that personal income deflated with the CPI will be higher in Q4 than in Q3, given that it is already so much higher in Oct and Nov than it was in Q3. The GDP deflator tends to be less volatile than the CPI, so personal income deflated by the GDP deflator will likely grow less. However, given that Oct and Nov NOMINAL personal income are a bit higher than the Q3 average and that the GDP deflator will fall Q3-Q4 (albeit less sharply than the CPI), it seems that personal income deflated by the GDP deflator will grow Q3-Q4 about 1 percent = 4 percent annualized.

From this perspective, the question is whether GDP could grow one percent (4 percent annualized) less than personal income. The differences between GDP and personal income include depreciation, retained earnings, net factor income paid to foreigners, and bunch of public sector items (plus estimation error in going from monthly to quarterly). Personal income is about 85% of GDP, so the residual between them would have to shrink by 7 percent (= 28 percent annualized) in order for GDP to grow 1 percent less than personal income. This another reason why I see a significant likelihood that real GDP growth Q3-Q4 is closer to real personal income growth, and thereby positive.

MY FORECAST
My point estimate for real GDP growth Q3 to Q4 is -2.5% (annualized rate). I get this by assuming that TFP follows trend (about 2% annualized; remember that I see that not much is happening with labor demand) and that labor falls 7%. 2 - (7 * labor's share) = -3. Then I add a little because personal income has done surprisingly well in November.

[some handwaving ...] Probability (real GDP Q4 higher than real GDP Q3) = 0.33."

Why not agree? As you know, I agree with him, but for different reasons. I believe that much of the job loss was proactive and uncalled for. That's why Productivity rose. Therefore, I'm committed to the view that the Fundamentals are in better shape than the forecasts, which are helping to drive this proactive job loss. Nothing is written, and, in a Human Agency Model, Expectations can effect human behavior, and so can change the facts by changing behavior. But no one is really following my predictions, and I'm a philosopher, and basing my conclusions on a philosophical analysis of human behavior to help understand this crisis. So, again, why not agree ?

"The "disaster" here seems to be isolated to durable goods."

Casey Mulligan and I form the Cock-Eyed Optimists Club:

"Monthly Consumption Growth: Highest in 7 years!

I mentioned that the Dec 24 BEA report showed a strong increase in real personal income. Now I notice some interesting patterns with real per capita consumption expenditures from the same report.


The "disaster" here seems to be isolated to durable goods. Of course, we are nauseatingly aware of the automaker woes( HIGH PRICED CREDIT NEEDED ITEM ). But real services (over 60 percent of total consumption expenditure) are actually higher( GOOD NEWS).

The news from Wednesday (ignored, of course, by the press) is that:

• per capita consumption expenditures (all types, deflated by CPI-all) were up in November for the first time since April. This is the largest monthly increase in more than seven years.( GOOD NEWS )
  
• per capita durable consumption good expenditures (deflated by CPI-durables) were flat in November ( GOOD NEWS )
  
• per capita services expenditures (deflated by CPI-services) were up in November, for the 20th month in a row ( GOOD NEWS )
  
• per capita retail sales (deflated by CPI-all) were pretty flat in November, after 5 straight months of losses ( GOOD NEWS )
  

Do we dare entertain the idea that the trough of this recession was in October? ( I DO )

[technical note: I used the CPI for all items to deflate retail sales and PCE - all. The CPIs for durables, nondurables, and services, respectively were used to deflate the components of PCE. I think this is the right approach, but in case you want to see the consumption series deflated with a common deflator (CPI-all), see below. I infer from the monthly inflation rates (Oct-Nov) that fuel costs appear in nondurables: -1.7% (all), +0.0% (durables), -5.1% (nondurables), -0.6% (services) ]

[added: Today it was reported that

• nominal Dec retail sales are down 5.5-8 percent compared to the same time frame last year. This is a different data source than I used above -- so we have to be cautious with comparisons -- but note that the retails sales data I used have a Nov-Nov change in nominal retail sales of -5.9 percent.
• amazon.com had the best holiday season ever.

So today's data is consistent with the expectation that December's consumption will be as strong as November's.]"

I believe that the immediate aftermath of Lehman, say through October, will be the high point for the level of Fear and Aversion to Risk and the Flight to Safety. Please don't consider this as anything important.

As you know, I consider the Historical Context to be the underpinning of any crisis, and I don't believe the situation is even remotely like the 1930s or even as bad as the 1970s.

"In the last three months, real wages did in fact rise at a 14.8 percent annual rate"

Dean Baker points out something that should be obvious, that, if prices on goods go down, and your wages remain the same or go up, your buying power increases:

"Suppose Real Wages Rose by 15 Percent and No One Noticed

Well, you don't have to suppose. In the last three months, real wages did in fact rise at a 14.8 percent annual rate, and no one in the media noticed, or if they did, they didn't bother mentioning it.

The basic story is simple. Nominal wages have continued to grow at a modest 3.2 percent annual rate. Meanwhile prices have plunged, mostly importantly the price of oil. This implies rapidly rising real wages. That is very good news for the folks who still have a job.

Reporters should have been talking about the surge in real wages, but they seem to have largely missed it. Here's a column I wrote on the topic."

There are some winners in Deflation. However, whether long term Deflation would effect some of these current winners negatively, is a good question. I wouldn't like to bet on it.

Felix Salmon, once again, has something to say:

"Dean Baker sees the upside of the recession:

You probably didn't see this in the newspapers, but real wages rose at an incredible 14.8% annual rate over the last three months. The basic story is straightforward. While nominal wages have continued to grow at a modest 3.2% annual rate, prices have plummeted, hugely increasing the value of the paycheques of those workers lucky enough to still have a job...
The real lesson that the public should learn from recent experience is how the income of one segment of society is a cost to others. The wealthy understand this point very well...
If they can get low-paid workers to tend their gardens, serve them meals in restaurants, paint their homes and serve as nannies for their children, it raises their standard of living...
In the same vein, when the rich lose wealth it is a gain to everyone else. In short, they have our money.

This doesn't feel right to me. Yes, it's true that the working classes saw their standard of living stagnate during the years when the income and wealth of the rich was soaring. But it's also true that the single event which most soured working-class Americans on Republican pro-rich economic policies was not the rich getting richer but rather the rich getting poorer when the stock market plunged in October. ( I HAVE A SLIGHTLY DIFFERENT PERSPECTIVE, WHICH IS THAT NO ONE CARES ABOUT THE RICH IF THERE'S A RISING MIDDLE CLASS AND A DECREASING LOWER CLASS, BUT THEY DO IF THE RICH GET WEALTHIER AND THE OTHER CLASSES STAGNATE OR SUFFER. MY PERSPECTIVE IS THAT ONLY A SOCIETY WITH A GROWING MIDDLE CLASS AND DECREASING LOWER CLASS IS SUSTAINABLE IN THE LONG RUN, AND IS THE ONLY REAL HOPE FOR A SOCIETY WITH A MUCH SMALLER GOVERNMENT, WHICH IS NO LONGER FELT TO BE AS NECESSARY. )

What's more, it's not easy to come up with examples of any country where the poor have seen a sustained increase in their standard of living as the rich have gotten significantly poorer. And if you're a low-paid waiter or painter or nanny, you're unlikely to feel better off when you're fired by your formerly-rich patron.( IF THE POINT IS THAT THERE WILL ALWAYS BE WEALTHY PEOPLE IN A FREE SOCIETY, THEN THE ANSWER IS YES. )

Baker's solution to this last problem is simple:

This just points to the urgency of a large government stimulus package. We need to replace the consumption of stockholders and homeowners with some other form of demand( I AGREE, BUT DISAGREE WITH HIM ON HOW TO DO IT. I BELIEVE IN SOCIAL SAFETY NET SPENDING AND INFRASTRUCTURE SPENDING THAT'S NECESSARY ON ITS MERITS, BUT I ALSO BELIEVE IN TAX CUTS. MY SOLUTION WOULD HAVE BOTH, BECAUSE I'M MAINLY FOCUSED ON ATTACKING THE FEAR AND AVERSION TO RISK. ). The government has the capacity to spend enough money to replace this demand (as Fed chairman Ben Bernanke said, we can always print more money( I AGREE).

This obviously isn't a permanent solution, and I wonder whether it's feasible even on a temporary basis( I BELIEVE THAT IT IS ). Does anybody have a ballpark number for how much the consumption of the rich has declined? I suspect that the drop-off in real-estate consumption alone is greater than any stimulus plan which we're likely to see.

But the real gain of the workers at the expense of the wealthy will come only if rents start declining. I'd love to see some numbers on the average rent paid by non-homeowners: does anybody collect that data?

Update: An email correspondent sends in some historical perspective:

In the US and much of Western Europe 1950-1980 the rich stagnated while the real standard of living of the rest improved.
In Revolutionary France the seizure of the assets of the aristocracy and the church and the elimination of many tolls, the emancipation of remaining surfs, and ending of the oppressive tithe system improved the standard of living of the middle and poor at the expense of the rich, at least those who did not die as cannon fodder.

Here's Casey Mulligan:

"Real Personal Income is Higher than Ever

[all of the statistics below are seasonally adjusted by the BEA or BLS]

Today the Commerce Department released its estimate of November nominal personal income, 12.1638 trillion dollars (at annual rates).

ECONOMICS 101: DIVIDE BY CPI

The press is emphasizing that the figure is 0.2 percent less than in October. But let's not forget that the BLS reported that consumer prices were down 1.7% over the same time frame. That means a real personal income INCREASE of 1.5% in just one month! ( TRUE )

We can argue about how exactly to deflate, but no resolution of that argument is going to change this 1.5% gain into a measure that screams disaster.

I'm not sure why the Commerce Department does not report real personal income, although at the bottom of its report it does show real disposable personal income, which was 1.0 percent HIGHER in November than in October. That's their calculation -- not mine -- so don't blame me from ruining your "economic disaster" parade.

Today's Commerce Department shows data back to April: over that time frame, personal income deflated by CPI was highest in November. I am pretty sure that makes November higher than ever!( COULD BE )

REAL PER CAPITA

If you like things in per capita terms, November real personal income (at a monthly rate) was $3311.61 per person. That's the second highest ever, with the first highest being $3311.79 per person in May. That's right, we missed the real per-capita record by 18 CENTS per person. Enough said! ( TRUE )

GUESS AT Q4 REAL GDP

The experts are saying that real GDP (at quarterly rates) will be more than 1 percent lower Q4 than Q3. Are any experts reading this? Can they explain to us why they have that expectation, given that October real personal income (quarterly rate) EXCEEDED the Q3 real personal income by 1.2 percent and November EXCEEDED it by 2.8 percent? Are you predicting that real personal income will fall more than 10% in just one month, in order to bring the Q4 average down that far? Or are you predicting a huge departure between the growth rates of real personal income and real GDP?

I am admittedly an amateur at high frequency forecasting (it has less to do with the basic economic forces I have been emphasizing, which may take a couple of quarters to work out), but there are enough significant inconsistencies with the experts' forecasts that I have to issue my own:

• Q4 real (and seasonally adjusted) personal consumption expenditure will fall less Q3-Q4 than it did Q2-Q3.
• Q4 real (and seasonally adjusted) GDP will fall less than 1.0% (that is: less than 4.0% at annual rates) Q3-Q4, and may rise.
• Q4 labor productivity will be higher than Q3's (that is, productivity growth Q3-Q4 will not be negative)."

I have to admit to being with Casey on this, so I pray that he's correct.

Here's Robert Frank from the WSJ about the decline in the fortunes of the wealthy:

"By ROBERT FRANK

Economic inequality has become a hot-button issue on the presidential-campaign trail, with Sens. John McCain and Barack Obama sparring about spreading the wealth in America. Yet even as the rhetoric about inequality is rising, inequality itself is falling, economists say.

The reason: The financial crisis is draining the rich of some of their riches.

Over the past week, the McCain campaign attacked Sen. Obama as "the wealth spreader" for his now-famous remark to "Joe the Plumber" that, "I think when you spread the wealth around, it's good for everybody." Sen. McCain also likened his Democratic rival's tax plan to socialism, because it would raise taxes on those making more than $250,000 and lower taxes, or keep them level, for the middle class.

"You see," Sen. McCain said in a recent radio address, "he believes in redistributing wealth, not in policies that help us all make more of it."

Sen. Obama, who made the growing U.S. wealth chasm a pillar of his campaign from the start, argues for more-progressive tax policies that would shrink that gap and allow more Americans to share in the country's economic gains. Campaigning in Florida last week, he said Sen. McCain's tax plans -- like President George W. Bush's -- would "give more and more to those with the most, and hope prosperity trickles down to everyone else."

But the debate over rich versus poor ignores the changes likely to result from the financial crisis. If history is any guide, the upheaval already is shrinking inequality and could continue to narrow the wealth gap.

The share of income held by the richest 1% of Americans has declined during each of the past three downturns. Between 2000 and 2002, their share fell to 16.9% from 21.5%, according to Internal Revenue Service income data compiled by economists Emmanuel Saez and Thomas Piketty.

Their share also fell during the 1990 recession, hitting 13.4% in 1992 compared with 15.5% in 1988. The steepest decline was during the Great Depression, when the richest 1% saw their share of income plunge to 15.5% in 1931 from 23.9% in 1928.

"The Depression may be the best analogy for today when it comes to what will happen with income shares," said Mr. Saez, an economics professor at the University of California, Berkeley. He predicts that the share of income held by the top 1% will probably fall to 18% or 19% in the next year or two -- down from an estimated 23% or 24% in 2007.

Getty Images

Sen. Barack Obama walks with Sen. John McCain and wife Cindy.

During the Depression, the assets of the wealthy declined along with their incomes. In 1928 the richest 1% held 36.5% of the nation's wealth; by 1932 it shrank to 28%. Studies by other economists and researchers show similar declines.

The main reason for the declines: falling stock values. The wealthiest Americans have a greater share of their wealth concentrated in stocks and financial assets. When stocks plunge, as they have lately, the rich are hit disproportionately.

The wealthiest 1% of Americans held more than half the nation's direct holdings of publicly traded stocks in 2004, according to the Federal Reserve. Stocks accounted for 11% of their wealth, compared with less than 3% for Americans in the 50th to 90th percentiles. The rich also earn more of their incomes from stock options.

Of course, the rest of America also is losing wealth and income -- from falling home prices, rising unemployment and declining 401(k) accounts. But rising inequality has largely been fueled by surges at the top, and without capital gains or soaring business profits, those gains will reverse.

Robert J. Gordon, an economist at Northwestern University, says job losses in finance -- which accounts for an outsize share of wealthy income earners relative to other industries -- also will shrink the income and wealth share of the rich. Government limits on compensation imposed by the economic-rescue plan also could have a mild impact, he said.

So could a narrower wealth gap become the silver lining of the crisis? "Only if you don't like rich people," says Len Burman of the Tax Policy Center. "It's not like their share decline brings improvements for the middle class or the rest of America."

The bigger question is whether the falling fortunes of the rich and the coming decline in inequality will alter plans to tax the wealthy more. Some Democrats in Congress are urging Sen. Obama to go further with his plan to raise taxes on the wealthy if he becomes president.

"Inequality became the central argument for raising taxes on the wealthy," says Alan Reynolds, senior research fellow at the conservative Cato Institute. "Now that's obviously wrong. To the extent that there were perceived excesses in CEO pay, a lot of those were from the investment banks. Now the investment banks don't exist. And some of those CEOs have lost their shirts."

Adds Edward Wolff, an economist at New York University: "Now that the top has taken this hit, I think the whole issue of inequality is going to move to the back burner. The political momentum to do something about inequality may be gone -- at least for now."

Some economists say it would be wrong to abandon efforts to restrain inequality based on a momentary fall.

"Inequality cannot be totally undone by the financial bust," Mr. Saez says. "Policy makers now have a golden opportunity, like Roosevelt, to do something more permanent."

Mr. Saez says the next president should follow the example of President Franklin D. Roosevelt and impose crisis measures -- tax increases for the wealthy, massive public-works and jobs programs -- that helped usher in more than 40 years of more even wealth distribution.

The fall in inequality is unlikely to last. Immediately after the 1990 and 2000 recessions, wealth and income shares of the top 1% resumed their upward march. The share of income held by the top 1% rebounded after the 2001 downturn to 22.8% in 2006 -- the highest level since 1928.

When the stock markets return, so will inequality."

There you go. The question is what happens to the wealth of the Middle and Lower Classes.

"But desperate times lead to desperate actions by desperate policy makers."

Roubini on ZIRP:

"The Fed decision to cut the Fed Funds range to 0%-0.25% has formalized the fact that, over the last month, the Fed had already moved to a zero-interest-rate policy, or ZIRP, and started a policy of quantitative easing (QE) as its balance sheet has surged over the last few months from $800 billion to over $2 trillion.

The Fed is now undertaking even more unorthodox policy actions. These actions are occurring while the U.S. and the global economy are at risk of a protracted bout of "stag-deflation" (stagnation and deflation).

While it is now fashionable to talk about such deflationary risks (and the latest U.S. Consumer Price Index figures confirm that we are entering into deflation ) some of us were worrying about the coming deflation well before the mainstream--concerned with short-run and unsustainable increases in commodity prices--discovered the deflationary risks in the global economy.

It was clear to those who saw, early on, the risks of a severe U.S. and global recession, that deflationary rather than inflationary pressures would emerge alongside a slack in goods, labor and commodity markets. Welcome to the world of stag-deflation or, as Paul Krugman would put it, the world of "depression economics."

So what is the outlook for 2009? And what is the likely policy response to the risks of a global stag-deflation?

The outlook for the U.S. and the global economy is now very bleak and getting worse as the global economy experiences its worst recession in decades. In the U.S., recession started last December and will last at least 24 months until next December--the longest and deepest U.S. recession since World War II, with the cumulative fall in gross domestic product possibly exceeding 5%.

In comparison, the last two recessions in 1990-91 and 2001 lasted only eight months each and the cumulative fall in GDP was only 1.3% and 0.4%, respectively. There is also a risk that this deep and protracted U-shaped recession (the mainstream consensus view of a V-shaped short and shallow recession is now out the window) may morph into a more severe Japanese style L-shaped recession unless aggressive fiscal policy and recapitalization of the financial system is enacted.

The recession in other advanced economies (the euro zone, the U.K., other European economies, Canada, Japan, Australia and New Zealand) started in the second quarter of this year, before the financial turmoil in September and October further aggravated the global credit crunch. This contraction has become even more severe since then. I don’t expect growth in the advanced economies to recover before the end of 2009.

There is now also the beginning of a hard landing (growth well below potential) in emerging markets as the recession in advanced economies, falling commodity prices and capital flight all take their toll on growth.

Indeed, the world should expect a recession (growth in the -1 to -2% range) in Russia and a near recession (growth close to zero) in Brazil next year, owing to low commodity prices. There will also be a very sharp slowdown in China and India that will be the equivalent of a hard landing for these countries. In China the latest figures for electricity use, exports and imports suggest that the economy is already close to the hard landing scenario of a growth rate of 5%. The deceleration of growth in China is much more rapid than expected.

Other emerging markets in Asia, Africa, Latin America and Europe will not fare better and some may experience full-fledged financial crises. More than a dozen emerging-market economies now face severe financial pressures: Belarus, Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania, Turkey and Ukraine in Europe; Indonesia, South Korea and Pakistan in Asia; and Argentina, Venezuela and Ecuador (a country that has just defaulted on its sovereign debt) in Latin America.

What is the policy response in the U.S. and other countries to this risk of a global stag-deflation?

The Fed decision to cut the target for the Fed Funds rate to the 0% to 0.25% range is just underwriting what was already obvious and happening in reality: While the target Fed Funds was until Tuesday still 1%, in the last few weeks--following the massive increase in liquidity by the Fed--the actual Fed Funds was already trading at a level literally close to 0%.

So the Fed just formalized what had already been happening for weeks now, i.e., that the Fed Funds rate was already zero and that the Fed had already moved to quantitative and qualitative easing (QE) in the form of a massive increase in the monetary base and aggressive use of monetary policy to reduce short-term and long-term market rates that are stubbornly high in a sign that the credit crunch is severe and worsening.

I predicted early in 2008 that the Fed Funds rate "would be closer to 0% than to 1%" in the midst of a severe recession. Now, 12 months into this severe recession--a recession that will last at least another 12 months (if not, as is possible, much longer)--the Fed Funds rate is already down to 0% (the beginning of the zero-interest-rate-policy, or ZIRP, for the U.S.) and the Fed has moved into uncharted unorthodox monetary policy as a severe stag-deflation is taking place.

And, as predicted by me over a month ago, the Fed is now committed to keep the Fed Funds rate close to zero for a long time (as a way to push lower long term Treasury yields); purchasing agency debt and agency MBS in massive amounts; and even considering purchasing long-term Treasuries as a way to push lower long-term government bond yields that are already falling sharply.

More aggressive policy actions may be undertaken by the Fed as a severe credit crunch shows no signs of relenting. In a 2002 speech on deflation, Ben Bernanke spoke even of helicopter drops of money, monetizing fiscal deficits and even buying equities.

The latter actions have already been partially undertaken: The Fed is effectively already monetizing U.S. fiscal deficits as the purchase of markets assets is financed with the Fed printing presses rather than the TARP program. And now, with the Fed considering the purchase of long-term Treasuries, such monetization of deficits will be made more formal.

Also, since the TARP has been turned into a program to recapitalize financial institutions (and thus boost their capital and market value), the U.S. has already effectively intervened indirectly in the equity market (by partially nationalizing a good part of the financial system). Once the Fed starts to buy the long-term Treasuries financing the TARP program, this indirect Fed purchase of U.S. equities will be even clearer.

While Fed actions to reduce mortgage rates--via purchases of agency debt and agency MBS--are partially successful as long-term mortgage rates are falling, most of the Fed purchases of private assets have been so far limited to very high-grade securities.

Thus, the gap between the yield on high-grade commercial paper purchased by the Fed and the one that the Fed is not purchasing is sharply rising; ditto for the gap between agency MBS and private label MBS. Also, while long-term Treasury yields are sharply falling, the spread of corporate bonds--both high-yield and high-grade--relative to Treasuries remains huge as a sign of a severe credit crunch.

Thus, as a next step, the Fed may be soon forced to walk down the credit curve and start buying private short-term and long-term securities with lower credit ratings. That would mean the Fed will take on even more credit risk than it is already taking on today while purchasing illiquid private assets. But desperate times lead to desperate actions by desperate policy makers."

This post seemed to be simply a list of what's happening. Not much to disagree with. As for the predictions, I've no idea.

"the current recession will do less harm to the typical family’s income than it does to many other parts of the economy."

I've started calling these "Silver Lining Stories", but to me, again, there is a difference between falling prices and deflation. Yet, even in deflation, some people would turn out to be better off. Not everyone loses in deflation. This is not a new point. I've already posted about the possible benefits of falling commodities prices. From the NY Times, David Leonhardt:

"Very few Americans alive today can remember a time when prices across the economy were falling. But they’re falling now.

Multimedia

Graphic

Deflation Rears Its Head

"The cost of fruits, vegetables, clothing and vehicles are all dropping. Housing prices have been falling for more than two years, and a barrel of oil costs about $45, down from $145 in July.

The inflation report released by the government on Tuesday showed that the Consumer Price Index was 3 percent lower last month than it had been three months earlier. It was the steepest such drop since 1933.

These declines have raised fears of a deflationary spiral — fears that help explain the Federal Reserve’s surprisingly large interest rate reduction on Tuesday. And there is good reason to fear deflation. Once prices start to fall, many consumers may decide to reduce their spending even more than they already have. Why buy a minivan today, after all, if it’s going to be cheaper in a few months? Multiplied by millions, such decisions weaken the economy further, forcing companies to reduce prices even more. ( THAT'S THE WORRY )

But a truly destructive cycle of deflation is still not the most likely outcome. For one thing, the price of oil cannot fall by another $100 in the next few months. For another, the federal government will soon, finally, be fully engaged in trying to stimulate the economy.( TRUE )

In mechanical terms, the Fed’s rate cut is actually a decision to pump more money into the economy (which will cause short-term interest rates to fall) ( QUANTITATIVE EASING, PRINTING MONEY, DEBASING THE COINAGE ). Starting next year, the Obama administration is planning to spend hundreds of billions of dollars on public works and other programs. ( STIMULUS, KEYNESIAN )

All else being equal, more money sloshing around an economy causes prices to rise. In this case, it will probably keep them from falling as much as they otherwise would have. ( TRUE. GRANT BELIEVES THAT THEY SHOULD BE ALLOWED TO FALL )

So amid all the legitimate worries about deflation, it’s worth considering what may be the one silver lining in the incredibly bad run of recent economic news: The cost of living is falling. ( TRUE )

Jobs are disappearing, bonuses are shrinking and raises will be hard to come by. But the drop in prices, which isn’t over yet, will make life easier on millions of people. It’s possible, in fact, that the current recession will do less harm to the typical family’s income than it does to many other parts of the economy. ( TRUE )

The reason is something called the sticky-wage theory. Economists have long been puzzled by the fact that most businesses simply will not cut their workers’ pay, even in a downturn. Businesses routinely lay off 10 percent of their workers to cut costs. They almost never cut pay by 10 percent across the board.

Traditional economic theory doesn’t do a good job of explaining this. During a recession, the price of hamburgers, shirts, cars and airline tickets falls. But the price of labor does not. It’s sticky.

In the 1990s, a Yale economist named Truman Bewley set out to solve this riddle by interviewing hundreds of executives, union officials and consultants. He emerged believing there was only one good explanation.

“Reducing the pay of existing employees was nearly unthinkable because of the impact of worker attitudes,” he wrote in his book “Why Wages Don’t Fall During a Recession,” summarizing the view of a typical executive he interviewed. “The advantage of layoffs over pay reduction was that they ‘get the misery out the door.’ ” ( I AGREE WITH ATTITUDES BEING THE CAUSE )

Companies resort to cutting jobs and giving only meager pay increases, increases that are even smaller than the low rate of inflation that’s typical during a recession. This recession may well be the worst in a generation — but thanks to the stickiness of wages, the pay drop for most families may not be much worse than that of a typical recession.( TRUE )

The forecasting firm IHS Global Insight predicts that prices will fall by an additional 1 percent in 2009. That would bring the total drop, from the summer of 2008 to the end of 2009, to roughly 4 percent. But you can be sure that most executives will not force their workers to take a 4 percent cut in their paychecks. The fears about morale will be too great.( TRUE. MORALE IS IMPORTANT )

Strange as it sounds, the drop in prices will keep real incomes — inflation-adjusted incomes — from dropping too much. ( TRUE )

I don’t mean to make things sound better than they are. The economy is bad and getting worse. A deflationary spiral remains a real threat, even if it’s not the most likely result. No matter what, unemployment is headed much higher.

People who keep their jobs, meanwhile, will suffer through some stealth pay cuts — higher health insurance premiums, for instance. Raises will also remain meager in 2010, even if prices start rising again. Like every other recent recession, this one will force families to take an effective pay cut, and a significant one.

But the drop in prices will still soften the blow. And at this point, American families can use any bit of economic help that they can get."

It's all true, but, remember, we don't know exactly what Deflation would actually lead to. It might well change the terms on which a lot of these silver lining stories are based upon.

"We should define "deflation" using economists' theory plus the philosophers' Principle of Charity "

I'm going to talk about Nick Rowe's post on Deflation, but first I need to talk about an old friend, and I mean a very old friend, called the Principle Of Charity.

So as not to bore people, I'm going to give a very cursory description of my position.

The Principle Of Charity, from my point of view, follows from Quine's Indeterminacy Of Translation. The Principle Of Charity can be used to explain how we can come to understand a foreign language. My basic problem with this whole mode of explanation is that the problem only exists if you are a Behaviorist, which Quine was. Davidson, more or less, works out of Quine's system. From my point of view, there's no Indeterminacy Of Translation, and no need for the Principle Of Charity. However, it does seem to have become synonomous with giving people the benefit of the doubt, assuming that they're rational.

Now, to Deflation.

"Some prices are falling, some are falling quickly, and some are still rising. Whether we've got deflation, and how much deflation we've got, depends on what you include in the index, with what weights, and over what time period. Do we include asset prices for example? It depends on how you define the word. Now you can define "deflation" to mean anything you want, but some definitions might be more useful than others."

This does seem to be the case. There is no clear definition of deflation.

"We fear deflation because aggregate demand for newly-produced domestic goods and services depends on the real rate of interest. The real rate of interest is the nominal rate minus expected inflation, and since deflation is just negative inflation, the real rate of interest is the nominal rate plus expected deflation. We fear deflation because deflation causes expected deflation, which raises the real rate of interest, which lowers aggregate demand, which causes excess supply and a recession, which causes deflation to increase. If we are close to the lower bound on nominal interest rates, this is something we ought to fear."

Essentially, we fear deflation for the same reason we fear a too high rate of inflation, i.e., it distorts the market in ways we don't like. Since most people, like William Gross, believe that capitalism works best with a little inflation, deflation is not a good thing in general.

"So right now, the best definition of "deflation" is the definition which maximises the truth-value of the sentence: "Aggregate demand for newly-produced domestic goods and services depends on nominal interest rates plus expected deflation". In other words, we should choose a definition of deflation which would provide the best fit in an estimated aggregate demand equation. We should define "deflation" using economists' theory plus the philosophers' Principle of Charity

http://en.wikipedia.org/wiki/Principle_of_charity

Let's see how this meta-definition works."

Fine. Lead on.

"If the price of antique furniture is falling, does that count as deflation? No, because even though people would postpone buying antique furniture if they expect prices to fall, this has no effect on current output and employment, because nobody produces antique furniture. (OK, the services of antique dealers might take a hit.)"

Okay. The decline in prices in some goods is not deflation.

"If the price of houses is falling, does that count as deflation? Yes, if it's new house prices that are falling, because people will postpone buying a new house if they expect new house prices to fall, which will reduce the demand for newly-produced houses. But old house prices (pre-owned?) don't matter, for the same reason that antique furniture prices don't matter."

Namely, they're already built. New houses need to be built, so to the extent that the demand for them declines, employment will decline, as will business profits. I think that's it.

"If the price of gasoline is falling, does that count as deflation? To the extent that people postpone buying gas if they expect falling gas prices, and to the extent that gasoline is domestically-produced, the answer is yes. But if the intertemporal elasticity of demand for gas is zero the answer is no. And if the gasoline is all imported (and if we hold the exchange rate constant), the answer is again no."

We're not producing it: No.
We're producing it: Yes.

"If the price of new cars is falling, does this count as deflation? Yes, if people postpone buying a domestically-produced new car. But perhaps we should also look at the cross elasticity of demand for mechanics, to keep the old cars running longer.

You get the picture. Anyone with an Euler equation, some elasticity estimates, and some estimates of the extent to which the good is currently produced domestically, can keep this list going."

Don't ask me. Maybe it's a pun on the word "oil".

"The key point is this: the weights on various goods which make up an index which creates a useful definition of deflation in the current debate over monetary policy with a zero lower bound will be very different from the CPI weights, because the CPI definition is designed to be useful for a very different purpose. (The best CPI weights are those designed to maximise the truth value of the sentence "If nominal income rises at the same rate as inflation, then utility is the same".)"

This makes sense. An index is useful only for defined measurements. One index seems to be measuring the production of goods, the other seems to be measuring the relationship between income and inflation. But I'm no expert.

"So, with that definition of deflation in mind, do we currently have deflation? Should falling share prices be included? (And I do mean "falling", not "low", because falling share prices will have different effects on consumption and investment demand than low share prices.) What's the time period? I don't have the answers, but I think I have a way to find the answers."

Now, my position is that deflation, however you define it, is capable of being defeated by the Fed. So, I see the only real worry to be inflation, because, as the definition of deflation says:

Deflation=A decline in prices that are:
1) Sustained
2) Broadly Based

I do not believe that it will be allowed to be sustained.