Paul Krugman says that there is reason to fear that two years from now we will be in deflation:
About that deflation risk - Paul Krugman Blog - NYTimes.com: Larry Summers has finally made the point I’ve been pushing for a while — that we’re at major risk of falling into a deflationary trap.... [T]here’s a clear correlation, driven largely but not entirely by the deep slump and disinflation of the early 1980s, and an implied slope of about 0.5 — that is, every percentage point by which real GDP fall short of potential [in a year] tends to reduce the inflation rate by about half a point over the course of the year. And right now the CBO is saying that in the absence of a policy action the average output gap will average 6.8 percent over the next two years. Do the math: if anything like the historical relationship between output and inflation holds, we’re looking at major deflation.
OK, maybe that relationship won’t hold — getting to actual deflation may take a deeper slump than merely reducing the inflation rate. And maybe a regression driven in part by 80s data isn’t a good guide to current events. But deflation is a huge risk — and getting out of a deflationary trap is very, very hard. We truly are flirting with disaster.
Greg Mankiw says that Paul Krugman is wrong: that we are not yet in deflation.
Greg Mankiw's Blog: Wage Deflation?: I am not convinced we are close as close to this precipice as Paul suggests. Stories of wage cuts are still anecdotal. Let's look at the data. Here is an excerpt from today's employment report:
In January, average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls rose by 5 cents, or 0.3 percent, seasonally adjusted. This followed gains of 7 cents in December and 6 cents in November. Over the past 12 months, average hourly earnings increased by 3.9 percent.
If we assume the normal 2 percent rate of productivity growth, 3.9 percent wage inflation is consistent with about 1.9 percent price inflation. So, at this point, widespread wage and price deflation seems more of a fear than a reality.