TIPS and the risk of deflation
The weak economic recovery, high unemployment rate, and recent slowing of inflation to a very low level suggest an increased risk of deflation in the United States (Liu and Rudebusch, 2010). However, the risk is lower if people expect inflation to remain stable at a positive rate. A brief period of negative inflation like the one observed during 2009, which was largely a consequence of dramatic declines in energy prices, should not pose a risk to the economy as long as it is viewed as a temporary phenomenon that does not alter longer-term inflation expectations. Measuring inflation expectations is a key factor in assessing the risk of sustained deflation. The challenge is to obtain reliable estimates of inflation expectations. This Economic Letter is based on a recently refined model that uses Treasury yields to estimate inflation expectations. The findings indicate that the heightened probability of deflation at the peak of the financial crisis has diminished considerably. Currently, the estimated probability is quite low.