After reading some basic papers on liquidity trap/zero interest rate/deflation from Eggertsson, Krugman and Ueda , I realise how difficult it is to overcome this economic situation. And one is never even sure of a deflationary scenario till it actually hits. So, I would agree to what Bin Smaghi says (be careful with D words) and instead use Bernanke’s words – an unwelcome fall in inflation (see my post here).
Now, the main story. UK CPI for November was at 4.1% , above the target of 2% (with a band of 1% on both sides). This requires BoE Governor to write a letter to UK Chancellor every 3 months. The letter of BoE Governor (Merv King) to Chancellor is here and reply of Chancellor is here. King says:
Nevertheless, taking all of these factors together, it is likely that overall CPI inflation will return to target in the first half of 2009 and then move materially below it later in the year. It is possible that I will not need to write a further open letter to you in three months time. Indeed, given the shortterm outlook for inflation, it is quite possible that I will next need to write to you to explain why inflation has deviated by more than one percentage point below the target during 2009.
The Chancellor agrees to the same and says in his pre-budget forecasts he expects inflation to fall to 0.8% in Q42009. The Chancellor also summarises the recent policy initiatives taken in UK for real and financial economy.
What made me interested was 0.8% figure. On seeing the last Fed projection for US economy , the expected inflation is for 2009 is 1.3% to 2.0%. So, UK looks really low which is expected as economy in UK is expected to be much weaker. Now, can this low inflation of 0.8% feed into expectations and lead to a persistence in really low inflation and then towards the dreaded “D” word?
Inflationary Expectations work on both sides. High inflation leads to high inflation expectations and higher inflation. Likewise, lower inflation lead to low inflationary expectations and a much lower inflation. Surprisingly, the evil is usually considered to be first but second is a much bigger and persistent evil as Japan tells us. There is tons of research on the upside of inflation expectations but hardly anything on the downside.
Interesting times surely. Reading through the current events is like reading the introductory textbook on economics where one is taught about events in 1929 Depression. I used to always wonder what is the relevance of teaching these concepts in these times. I couldn’t have been more wrong.
Mostly Economics 
