Here comes inflation

by Russ Roberts on February 12, 2009

in Inflation

Greg Mankiw notes that deflation worries have subsided and points to this chart showing that inflation-adjusted Treasuries (blue line) no longer have a higher yield (anticipating deflation) than unadjusted Treasuries:

Inflation compensation

Mankiw writes:

The negative inflation compensation that showed up a few months ago
(when the blue line was well above the red) has shrunk to about zero.
These relative yields are moving back toward a more normal, and
healthier, alignment.

I have a feeling the word "healthier" isn't going to be accurate for very long. Yes, the red line will be above the blue one, meaning that the market is anticipating inflation. But the gap is going to soon be so large that it won't feel healthier.

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baldusco February 12, 2009 at 1:29 pm

I would prefer to say "Here comes the sun…"
It's sad.

Greg Ransom February 12, 2009 at 1:39 pm

Are there typically productivity gains during recessions, i.e. businesses squeezing out greater output at lower cost (productivity gains), i.e. is there a some margin of beneficent deflation during a recession?

I'm guessing here is.

If so, the true rate of inflation is larger than that assumed by Greg Mankiw.

Greg Ransom February 12, 2009 at 1:40 pm

I should say:

If so, the true rate of anticipated inflation is larger than that assumed by Greg Mankiw.

Mezzanine February 12, 2009 at 1:58 pm

Muirducks say there is no inflation when government prints money. Of course he wants to tax the hell out of that 5% to pay for it all….

Lee Kelly February 12, 2009 at 3:14 pm


Why do you have to bring muirgeo into this? At least wait until he posts. Then, if he never posts, we are all spared the his mention.

Lee Kelly February 12, 2009 at 3:22 pm

In any case, there is no inflation when the government prints money, only when they decide to spend it (and it does not need to be the same physical notes).

Mezzanine February 12, 2009 at 3:35 pm

Lee – I'm just sparing us the inevitable trauma of muirduck by posting what he'll say anyways. That way when he actually comes it will be like "oh we already heard that" and we can have a laugh.

Lee Kelly February 12, 2009 at 4:15 pm

Greg Ransom,

Well, I think deflation is a good thing.

Assume that an economy does not increase its output from one year to the next, that is, its rate of investment merely compensates for its capital depreciation. Investment is funded by bank loans. In some years capital depreciation is greater than in others.

But there is a problem. When A stops buying B's product and saves, whatever gain there is in A's bank account is offset by an equivalent loss in B's account. Although a particular bank might increase its reserves, the total of available funds to lend in the banking system remains constant.

The banking system cannot lend more money to compensate for greater capital depreciation. By saving money, A has merely deprivsed B of income–the Keynesian paradox of thrift. How then, can investment increase through saving?

There are two ways that investment could increase. One is that available funds to lend increases, but for the reason described above this cannot be. Second is that money in the bank gains in purchasing power, and it is here we find our answer.

When A stops buying B's product and saves, it exerts a downward pressure on prices. Any money then lent by the bank then has greater purchasing power. Since saving is also the opposite of borrowing, demand for credit declines and interest rates fall.

Deflation then, as it is defined by government statisticians, is one way in which saving manifests itself. So our economy can compensate for greater depreciation of its capital through saving. The Keynesian paradox of thrift is, in fact, an accountancy trick.

It seems to me that deflation (i.e. a fall in prices) is a good thing. Deflation can only be prevented by interfering with the price signals from which it is derived.

Alan Burton February 12, 2009 at 4:24 pm


As a chemist, I find this usage of the word precision to be painful. Precision in physical sciences means the ability to reproduce results. The term accuracy is used to describe the closeness to the true value of the determination. One can be precise as in creating a tight shot pattern that totally misses the target. Accuracy means that one has hit whatever target is assigned. You can see this at a rifle range with a maladjusted sight versus one that is properly adjusted.

A politician may be precisely wrong most or even all of the time. There are many examples. Accuracy is tougher to achieve.

This may seem a minor quibble but for a scientist, it is troubling.

Lee Kelly February 12, 2009 at 4:54 pm

Alan Burton,

You find Russ's use of the word 'accurate' to be painful? Government regulation of the words 'accurate' and 'precise' is needed so that you no longer suffer this degrading externality. Contact your local representative.

Dave February 12, 2009 at 6:56 pm

I too worry about high inflation eventually. I certainly do not know for sure, but I suspect that rampant inflation will not return for awhile though, based on the experience of other popped asset and credit bubbles.

Here are long term rates during debt deflations of the past. They tend to continue their downward trend for quite some time, indicating that inflation was not problematic. Of course, this time could be different, and politicians seem hellbent on throwing money at our problems, which may lead to monetizing our public debt, but I also suspect that credit still has much farther to contract and won't recover anytime soon, providing downward pressure on prices for at least a few years.

Long story short, I wouldn't expect that a 5-year forward-looking inflation indicator to pop up too high anytime soon, although this time might be different.

Hammer February 13, 2009 at 10:37 am

While I prefer deflation to inflation, it is important to bear in mind that deflation is rather destructive to those who have debt to pay off. Perhaps less damaging to individuals since wages are fairly sticky, but definitely problematic to some businesses who would see lower revenue but relatively static costs (assuming labor and capital costs are more significant than raw materials or product). I don't know if that would be likely to cause unemployment or not.

If, as I suppose, keeping the money supply relatively stable is not an option for the Fed, I suppose deflation is the way to go. Presumably we should have natural deflation over the long run as productivity increases, but large swings in the short run are worrisome to me.

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