OXFORD – Central banks can stop worrying about inflation. Price deflation is far more likely in the near term. But temporary deflation need not be the terror that central bankers fear, at least if the banking system is recapitalized and if interest rates in the industrial countries fall sharply.
As recently as September and October, the United States Federal Reserve and the European Central Bank both saw the risk of inflation as being roughly equal to the risk to growth. Both were reluctant to lower interest rates markedly. Indeed, financial markets may have taken the Fed’s view on US inflation as representative of other central banks’ outlook on inflation, reinforced by the surprising ECB decision of October 2 to keep interest rates on hold.
In October the US was on the cusp of the most significant turning point for inflation in the last 20 years. Of course, forecasting inflation is notoriously difficult. There have been large structural shifts in the world economy (e.g., trade and financial globalization) as well as in individual economies (such as the decline in trade union power). Monetary policy itself has shifted to a far greater focus on inflation.
Moreover, energy and food price shocks can be both large and largely unpredictable, while the speed of price changes tends to increase with big shocks. Most forecasting models used by central banks therefore put a large weight on recent inflation. This approach tracks inflation quite well, except at turning points , because the models miss key underlying or long-term influences.