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: Having raised the alarm on deflation, the Federal Reserve has now begun to sound the all clear. The statement it released after its policy meeting on June 24 notably omitted the warning from its three prior meetings that “inflation could persist for a time below rates that best foster economic growth and price stability”. To be sure, with the economy gradually finding a bottom and the rate of decline in home prices slowing, the chances of a downward spiral of deflation and economic activity have diminished. Yet it seems premature to write off the threat as long as a large output gap persists. The output gap is the difference between actual economic output and the most the economy could produce given the capital, know-how and people available. When actual output exceeds potential, demand for products and labour bids up prices and wages, fuelling inflation. When actual output falls short, competition for scarce sales and jobs puts downward pressure on inflation.

Estimating how big the output gap is, and how much of a deflationary threat it still poses, is not easy. The Congressional Budget Office (CBO) estimates that the gap topped 6% in the first quarter of this year and will average more than 7% in 2009, which would be the largest figure on record. Given that core inflation was so low when the recession began, it is not a stretch to believe that, with so much slack in the economy, it could yet turn negative. But this view has been challenged in a note by John Williams and Justin Weidner of the Federal Reserve Bank of San Francisco. Rather than follow the conventional route of deriving an inflation forecast from an estimate of potential output, they do the opposite: they infer the output gap from the behaviour of inflation. As in the euro zone, where consumer prices fell for the first time ever in the 12 months to June, and Japan, where inflation excluding perishable food was -1.1% in May, inflation in America is now negative because of a drop in fuel prices last year. But core inflation is 1.8%, within its range this decade. The authors take this as evidence that the output gap may have been only 2% in the first quarter, implying little or no threat of deflation.

Nairu’s non-alignment