It’s a schizophrenic world. On one side, there are lots of people worried about hyperinflation , despite forward looking indicators of inflation signalling quiescence  and actual price indicators going downward.
On the other are those who actually look at the data, and then conjoin their observations with information on the tremendous slack in the economy, and say that rapid inflation is unlikely. So while all eyes are on this Friday’s CPI release, I assert that we don’t really have to wait to find out the trajectory of inflation. In this post, I will highlight the fact that over certain horizons, we already have deflation; and for certain segments of the population, inflation has been at zero for a year already.
First, consider standard indicators. The core CPI and core PCE deflator inflation rates are still positive.
Figure 1: Core CPI (blue) 3 month annualized inflation, and core personal consumption expenditure deflator (red) 3 month annualized inflation. Gray shaded area denotes recession, assuming trough at 2009M06. Source: BLS and BEA via FRED II, and NBER, and author’s calculations.
For discussion of differences in coverage, weights, and construction between CPI and PCE, see this post. From these conventional indicators, it would seem we are still aways from deflation.
Measures of Inflation, by Income Group
It is important to keep in mind that the impact of price changes on the cost of living differs across income groups, as I discussed in this post. Figure 2 depicts the 3 month annualized growth rate in the CPI as it pertains to the 1st, 3rd, and 5th income quintiles.
Figure 2: Three month annualized inflation calculated using guesstimated CPI ex.-energy for first quintile (blue), third quintile (red), and fifth quintile (green). Guesstimated CPIs calculated as arithmetic averages of component indices; excludes “private transportation” and “fuel and utilities” from the housing component. Source: BLS, and author’s calculations based on weights in Kokoski (2003), Table 5.
A caveat: I call these guesstimates because I am not always certain that the categories I have selected match up with the series Kokoski uses in her calculations. In addition, I do not believe that my ex.-“energy” series matches up with the construction of the official CPI excluding energy and fuel series reported by the BLS. I welcome cross-checking. However, I think the deviations of the movements by quintile should be representative.
Clearly, (3 month annualized) inflation for the 5th quintile is very close to stall speed, at about half a percentage point in June 2010. In contrast, inflation being experienced by the 1st income quintile is nearly 1 percentage point. Another way to highlight this difference is to examine the (log) levels of the indices.
Figure 3: Log guesstimated CPI nerg ex.-“energy” for first quintile (blue), third quintile (red), and fifth quintile (green) (2000=0). Guesstimated CPIs calculated as arithmetic averages of component indices; excludes “private transportation” and “fuel and utilities” from the housing component. Source: BLS, and author’s calculations based on weights in Kokoski (2003), Table 5.
Notice that the 5th quintile CPI ex.-“energy” is essentially flat since 2009M07. Running a regression on first differences (remember log price indices are at the very minimum I(1), and arguably I(2) over some samples), one finds that the implied annualized inflation rate is 0.3 percentage points, and is not statistically significantly different from zero at the 10% msl. In contrast, the core CPI inflation rate over the corresponding period is 1 percentage point, and is significantly different from zero, with a p-value of 0.015 (both regressions using HAC standard errors, 2 lags).
Why should one care about the 5th quintile? If one is concerned about aggregate consumption, then it is of interest to know what happens to the top 20%. According to Moody’s, about 60 percent of total consumption is accounted for by this quintile . If the price level facing this group is falling, then they might either defer consumption in anticipation of yet lower prices, or either increase or decrease consumption in response to changes in wealth (depending on whether they are net creditors or debtors). (The overall CPI weights, according to Deaton, corresponds to about the 75th percentile in income.)
The CPI-all inflation rates (3 month annualized) for the 3rd and 5th quintiles have been negative since May and April respectively. Even that for the 1st quintile has declined as of June. This matches up with the declining inflation for the standard CPI-all, since May.
We know that the CPI is upwardly biased, due to the use of fixed weights for the major categories. That means that if one could apply a Fisher ideal index to these data, for each quintile, one would probably obtain more negative inflation rates. 
We have forward looking market-based indicators of expected inflation. One is the spread between the 5 year Treasury rate and the corresponding 5 year TIPS. Keeping in mind the problems with using the spread to infer inflation , here is the picture.
Figure 4: Difference between five year and five year TIPS constant maturity yields (teal), and five year TIPS constant maturity yields, monthly averages of daily data. Observations for August denote data for August 5, 2010. NBER defined recession dates shaded gray. Source: FREDII and NBER, and author calculations.
With these points in mind, and with tremendous slack in the economy, rapid inflation seems like the last thing one should worry about. Or crowding out, for that matter .
Update: 11:30am Pacific, 8/10/2010
Oscar Jorda has just sent me a note written by a UC Davis PhD student, Paul Gaggl, which reports the unconditional forecasts and associated fan charts for a simple four variable VAR (GDP growth, PCE inflation, Fed funds rate, ten year bond rate). Pay close attention to the top rightmost graph in the chart.
Figure 1 from Gaggl (2010).
I’m not saying this particular VAR is the definitive word in how to model inflation, but I think it indicates the fact that based upon historical correlations, there is ample evidence to support the view that deflation is very possible. (The referenced Jorda/Marcellino paper is here)
In other news, WSJ RTE/Izzo reports:
A Wall Street Journal survey found that by a two-to-one margin Wall Street economists see deflation as a bigger threat to the U.S. economy over the next three years than inflation.
“Deflation is dangerously close,” said David Resler of Nomura Securities, one of 53 economists surveyed by the Wall Street Journal. Among economists who answered the question, nearly two-thirds said that deflation poses the bigger risk to the economy over the next three years; the remainder said inflation is the bigger threat. That compares to an April survey, when the economists were split 50/50 over whether inflation or disinflation posed the bigger risk over the next year.