Deflation, Equilibria, and QE2
The BLS provided the October Consumer Price Index release today. The October core CPI year-on-year growth was 0.6 percent. This is the lowest growth of this measure since 1957. This rate of growth is low enough that the Fed is concerned that price growth is too low. In an economy characterized by weak demand, weak job growth, and an anemic recovery from a harsh recession, we are rightly fearful of “bad deflation”. Bad deflation is a self-reinforcing downward spiral in prices and demand that would bring purchases to a halt as households and firms would wait for a better deal.
I have characterized the current situation as a “good-deflation” macroeconomic equilibrium where consumers see low price growth as helpful in maintaining moderate spending in a jobless economy, producers see low price growth as helpful in maintaining costs, and the FED is able to maintain historically low interest rates without worrying about inflation. If the recovery remains job-less and weak then the probability that the economy could switch to a “bad-deflation” equilibrium is uncomfortably high.
The business press has commented that today’s inflation data provides validation of Chairman Bernanke’s decision to proceed with a second-round of quantitative easing, QE2. I do not think that QE2 will provide much stimulus, in part because it is already priced in and because there are too many other structural economic problems, see my exposition here.
While the low inflation number reported today adds to my nervousness about slippage toward bad-deflation, it is not the case that QE2 is validated by today’s data. QE2 alone is not enough. The large variety of structural problems that still exist must be addressed to promote macroeconomic health.