Inflation? Deflation? Both?

Of course, not at the same time. However, this question has been on my mind recently.

First, a quick Econ 101 review (I had to look this stuff up, I swear) courtesy Wikipedia:
Inflation: "In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. ... A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time."
Naturally then, Deflation: "In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below zero percent, resulting in an increase in the real value of money — a negative inflation rate. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when the inflation decreases, but still remains positive). Inflation reduces the real value of money over time, conversely, deflation increases the real value of money." (here's another good explanation article on deflation from Inflationdata.com)

One further important point: headline vs. core inflation. Core inflation uses a CPI that excludes food and energy prices. This has, in recent times, been controversially viewed as a more accurate measure of inflation. The argument for it is that food and energy prices are too volatile to be considered as part of CPI. It's important to note that the Fed tends to use core inflation as it's guide, though they've recently had to review that policy. The controversy stems from the fact that, one, consumers *do* need to pay for food and energy, and two, there are more volatile aspects to CPI than food anyway, according to research from the Philly Fed.
Yikes, eh? Makes things pretty complicated. And to make things even more fun, headline inflation is negative while core is slightly positive.

It's important to note that what needs to be avoided is hyper-inflation and deflation (this also is arguable, but let's go with conventional thinking for now). As far as I know, it's generally accepted that moderate inflation is considered the most healthy scenario for an economy. I draw heavily from the SF Fed for the following analysis:

• High inflation is dangerous and prevents economic growth: for example, price change in a product could no longer be easily define by supply and demand if inflation could just as easily be the cause. Also, high inflation tends to have higher fluctuation, which causes consumer and investment uncertainty.
• Zero inflation is dangerous because this usually implies lending rates close to 0, which leaves the Fed very little room for stimulus if necessary.
  
• Thus, you're left with moderate inflation as the safest path. Kinda roundabout, but hey - that's what I've gathered so far.

We also need to address why deflation is generally considered dangerous (again, from SF Fed):

• In deflation, prices are falling throughout the economy - and that actually sounds kinda nice at first glance, from a consumer's perspective. However, keep in mind that deflation increases the burden on borrowers (read: consumers) in the case of a fixed-rate loan, and prolonged deflation can reduce the value of collateral, again making borrowing (credit) more difficult to come by. Lastly, again, the Fed would probably be stuck at 0% interest rates and would be unable to properly stimulate the economy.

Ok. All that's out of the way. I think we have a very rudimentary understanding of what we want, and what we don't. So, what might be coming?

It's good to get a review of what can actually cause inflation and deflation.

What can cause inflation:

• Increasing supply of money
  
• Decreasing supply of goods
  
• Increasing demand for goods
• Decreasing demand for money

Deflation is the opposite:

• Decreasing supply of money
  
• Increasing supply of goods
  
• Decreasing demand for goods
• Increasing demand for money

The inflation-is-coming faction bases their claims on the Fed's liberal pumping of money into the economy (first bullet for inflation). Though CPI has been falling, many attribute this to dramatic falls in food and energy prices, as well as dramatic falls in rental and property prices - and despite all this, notice Core CPI never went negative!. When these factors begin to recover, inflation will jump with it.
The deflation-is-coming camp, however, notes that there has indeed been negative Headline CPI, and that there is no guarantee prices will recover. Even despite the recovery in energy prices, which will force headline CPI back up, rent and wages are still falling and will be much more serious components of the measure.

I'm leaning towards the deflation camp in the short term. Layoffs are on-going, and though they're slowing, they're still happening! This means lots of people with less purchasing power, which will force rents down and the price of goods down, based on decreasing demand. The Fed already has interest rates at 0 - if things go bad, they won't be able to easily stimulate things again, which is further danger of deflation. And yes, I believe we're not out of the woods and that we are likely in line for a U- or W-shape recovery.
In the long-term, however, the picture is more murky. The Fed has pumped a LOT of money into the system (take a look at their balance sheet! I link to that in the Econbrowser article below) and if/when recovery occurs, that increased supply could make for serious inflation.

Here are some good reads on the topic:

• Krugman (deflation-oriented)
  
• David Rosenberg (deflation-oriented)
  
• Seeking Alpha (inflation-oriented)
• Econbrowser (inflation-oriented, very very good read)
  

Lastly, I'm no expert on ANY of this stuff. I hardly know monetary policy. Please, if anyone has more insight, feel free to comment and criticize. I would love to understand this better.

A few follow-up points I think are important:
1. It's unclear that deflation is necessarily bad. Many tend to use the Great Depression or Japanese experience as examples of why deflation is bad; in fact, it can be argued deflation occurred during the Industrial Revolution (supply of goods increased dramatically) and this was a good thing. So, deflation could be good or bad depending on the situation. This is taken from the Inflationdata.com article linked earlier in this post.
2. There are many debatable measures of inflation. I tried to stay with mainstream analysis for this post.
3. This is all based on the conventional definition of money supply where money is currency. I didn't discuss money supply enough in this post, but it is very important in understanding inflation.

**UPDATE** The market and the Fed seem to disagree on where interest rates are headed, which implies differing views on coming inflation (the market seems to think it's more likely than economists do).