Does Deflation Threaten the Global Economy?

Abstract

What probability can we assign to the outlook for global deflation? Recently, much of the discussion around monetary policy in the United States, Eurozone and Japan has focused on the threat of deflation and how to avoid it. How likely is deflation for each of these countries, and more broadly, for the global economy as a whole? This paper provides an early-warning-system (EWS) to predict the probability of inflation/deflation in the near term. Specifically, we utilize an ordered probit approach to estimate the six-month ahead probability of three distinct scenarios for the inflation outlook: inflationary pressure, deflationary pressure or price stability. We build models for five regions to generate a signal for each region's inflation outlook. Our first model assesses the inflation/deflation outlook for the global economy, while the second model generates the likelihood of each inflation scenario for the advanced economies. Our final three models forecast the probability of inflation/deflation for the United States, the Eurozone and Japan. Our global model suggests deflationary pressure is more likely than the other two inflation scenarios, with the model forecasting a 99 percent chance of deflationary pressure in the next six months. The advanced economies model suggests a 58 percent chance of deflationary pressure. The probability of deflationary pressure for the United States is 60 percent, 72 percent for Japan and 56 percent for the Eurozone. Since 2013, all five models have consistently suggested that deflationary pressure is the most likely of the three scenarios. Given the historical accuracy of these models, and by combining all these signals into one framework, we predict that the risk of deflationary pressure is much higher than the other two inflation scenarios for the global economy in the near term.