Deflation is here. The question before the house: How long it will last?
Ideally, it’s just passing through, albeit throwing everyone into a temporary tizzy with worries that the U.S. is set to repeat the Japanese experience. Certainly the Federal Reserve is working over time in trying to make sure the disease is short-lived. But for the moment, at least, prices are generally falling, as we’ve discussed, including here.
The great experiment in trying to keep a sustained case of deflation at bay is upon us. The immediate danger is that consumers and businesses expect deflation to persist. As many studies have shown over the years, along with more than a fair bit of empirical evidence, expectations are critical factors in determining the level of inflation and its cousin, deflation. Once the Fed loses the battle on managing expectations, monetary policy becomes much weaker.