It gets more complicated, of course. The largest complication is that businesses have relationships – and often contracts – with both customers and employees, and unanticipated changes in prices and wages can disturb those relationships. Consequently, businesses anticipate changes in prices, wages, and market conditions, and they set their own prices accordingly, in the hope of minimizing future surprises. As a result, inflation tends to have momentum. If prices have been rising by 2 percent per year, businesses anticipate that price growth, and the actual inflation rate – under idealized “normal” conditions – comes out close to 2 percent per year. But if the unemployment rate is very low, competition for workers forces businesses to raise prices more quickly, and the inflation rate rises. And if the unemployment rate is very high, competition for customers forces business to raise prices more slowly, and the inflation rate falls.
So much for the theory. I could add a lot more complications – the supply and demand for money, the difference between flexible and sticky prices, the impact of different degrees of competition, the various ways businesses might form expectations about prices, the relationship between unemployment and job vacancies, the possibility of structural changes in the economy over time, and so on – but let’s just stop here and take a look at the evidence in its simplest form. (To produce the chart below, I first took the rate of change in the core CPI from December to December for each year. Then I subtracted the previous year’s rate of change from the current year’s rate of change, for each year in the sample, and I plotted the result against the average unemployment rate for the current year. The core CPI series starts in 1957, so the first observation for which I could compute the change in the inflation rate is 1959. All the underlying data are from the Bureau of Labor Statistics.)
![](https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgQbQt8IxZlqac0OFrQGEeZcKhuNHib83CMnwUXZH-R3x6YSke1fE4SPeycGMOkX4MCX-drzfNVlDUOA42KPm76Yd1bIumU9SeA3wXXY5nFWSkvWCZL_Y4q9CEnnLAmOAI_3TsewN4G_pg/s400/philCurv.jpg)
The correlation isn’t perfect – and we wouldn’t expect it to be, since there are other factors that affect the inflation rate in the short run. But it’s strong enough to be quite statistically significant.
And under today’s circumstances, it’s strong enough to be disturbing. The core inflation rate for 2009 was 1.8 percent. If you take the regression line at face value and plug in an average unemployment rate of 9.6 percent – a little toward the low end of what most economists expect for the year – it implies a 1.8 percentage point decline in the core inflation rate. And if you look at the actual data for January through April 2010, we are right on target for a zero percent core inflation rate. I probably don’t have to point out that the unemployment rate will almost certainly still be quite high in 2011, and it won’t be low in 2012.
The May CPI comes out tomorrow morning. It’s expected to show a very slight increase in core consumer prices. If it does show only a very slight increase, or no increase at all, how many will report that “inflation is still under control” and describe it as good news? If you’re worried about the black swan of inflation, I guess it is good news each month that the black swan doesn’t appear. But under today’s circumstances, the white swan – the common species that past experience would lead us to expect – is deflation.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
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Why is no one really talking about deflation? It seems the only obvious reaction with the amount of wealth destruction, more to come I expect as housing tries to find a natural floor, and high unemployment. With the amount of debt, household and otherwise, that so many hold, it seems this should be the #1 story and thought on everyones mind and the biggest threat to future growth.
Yeah, its crazy that folks can't see what's right in front of their faces. The deflationary forces out there are staggering. Government response has been large, but you can't stop a toilet once its started to flush.
There are trillions and trillions of dollars debt out there with no assets behind them. Much of this debt can never be paid off. The Fed will not, indeed cannot raise rates for a very long time.
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