Where is inflation?

With so many hundreds of billions of dollars being pumped into the US economy over the past 10 months one would expect, based on conventional wisdom, an increase in inflation rate. However, there has been a disinflationary trend since July 2008 and inflation rates have been in negative territory since March 2009. How can this be possible?

Currently, there is a real risk of deflation, which is more difficult to manage through monetary policy than inflation. The government's expansionary fiscal policy through increased spending should be expected to raise interest rates and raise inflation by putting more money is consumer's pockets. The reality is exactly the opposite.

According to the DAD-SAS macroeconomic model, at equilibrium inflation and potential output (GDP) are defined by the point where the positively sloped aggregate supply curve (SAS) and negatively sloped aggregate demand curve (DAD) intersect. When the equilibrium is disturbed, actual output could either be higher (if DAD curve shifts to the right) or lower than potential output, causing a corresponding output gap. A negative output gap will cause a downward pressure on inflation rate and shift the SAS curve to the right/down until output (GDP) is once again at its potential, or at equilibrium.

Expansionary fiscal policy will shift the DAD curve (causing a positive output gap) to the right and put an upward pressure on inflation rate. This will decrease the output gap until actual GDP is once again at potential. The result is a permanently higher inflation rate. This is the theory based on which we expect to see high levels of inflation given the high levels of government spending. The actual data indicates exactly the opposite. So, lets analyze what could have happened.

What we are missing in the above analysis are high unemployment rates (9.1% as of May 2009) and consequently lower levels of household incomes, lower levels of corporate investment and a shaken consumer confidence. All these factors cause the DAD curve to shift to the left and apparently the leftward shift has been greater than the rightward shift expected from the stimulus-based spending. Based on the recent disinflationary trend, we can infer that the actual GDP is below potential GDP causing a negative output gap. In fact, the Congressional Budget Office estimates that we'll end 2009 with actual GDP 8% below potential. In order to return to equilibrium, inflation has to drop further (reducing the negative output gap). The greater fear now is deflation, not inflation.