Deflation Watch

Do Most Economic Observers Underestimate the Threat of Deflation?

Bank of America Merrill Lynch has just issued a sobering assessment about the U.S. and European economies:

Despite the ongoing economic recovery, we believe there is a significant risk of either a continued drop in inflation or outright deflation in one or several advanced economies over the next several years.

In addition, the financial giant believes central banks, economists and investors underestimate these risks.

Here's an excerpt from the March 21, 2014 BofA Merrill Lynch report titled, "Developing deflation":

As inflation continues to fall across the developed world, central bankers almost universally argue that deflation is a very remote risk. The markets and most economists don’t seem worried either. For example, the Atlanta Fed calculates the probability of deflation priced into the US TIPS market. Their latest reading a few days ago: a 0.0% probability of the CPI dropping over the next five years.

This complacency is shared by most economists. The latest survey of professional forecasters by the ECB—taken in mid-January—found that the average forecaster expected inflation to double from 0.7% to 1.3% over the next 12 months and then continue to rise to 1.5% in the 12 months after that. Moreover, more than half of the respondents saw a zero probability of deflation in either 2014 or 2015.

Professional forecasters in the US are equally optimistic. They share the Fed’s inflation forecast—the consensus sees core PCE inflation jumping to 1.6% in the year head and to 1.9% by 2016. Moreover, the average forecaster sees only a 0.2% chance of deflation in 2014 and 0.4% in 2015. Even with inflation steadily falling over the last two years, they see only an 8% chance that core PCE inflation is below 1.0% yoy this year and only a 7% chance for next year.

The report elaborates on why economic observers should not be complacent about a continued drop in inflation or deflation.

[W]e argue that it is not hard to come up with scenarios where deflation occurs. Core inflation has been trending steadily lower over the last two years. Over that period, the consensus has repeatedly forecasted that an upturn is just around the corner, only to see inflation fall further. What if that forecast error persists?