Bank of Japan, Tokyo.

Global Financial Crisis: Inflation was a pressing concern of central bankers until recently but in a time of dizzying change, the latest scare is deflation and the experience of Japan's lost decade is a potent reminder of its impact.

Nouriel Roubini of New York University’s Stern School of Business,who predicted the financial crisis in 2006 and earlier this year was dismissed by many as the ultimate Dr. Gloom, when he foresaw the dénouement in September, that followed the collapse of Lehman Brothers and the rescue of insurance giant AIG.

Professor Roubini recently told Bloomberg News that the global economy is entering a period of stag-deflation.

“The US, other advanced economies and even emerging markets will have recessions at the same time,” he says

Bank of England Monetary Policy Committee member David Blanchflower says that UK interest rates need to fall soon and ``significantly'' to stave off the threat of deflation as the economy endures a recession throughout the next year.

``Interest rates do need to come down significantly -- and quickly,'' Blanchflower said in a speech at the University of Kent on Wednesday. ``If rates are not cut aggressively we do face the prospect of a relatively deep and long-lasting recession.''

David Rosenberg, Merrill Lynch's chief US economist, believes that deflation will occur, adding to the recessionary environment North America already finds itself in and potentially delaying the nation's economic recovery.

In a research note, Rosenberg wrote: "We believe the next major macro theme is deflation. To be sure, the CPI has not declined on a year-over-year basis. In fact, it is coming off a cycle high of more than 5% during the summer. But, just as the real economy was ‘recessionary’ a year ago before GDP turned negative, the pricing backdrop is ‘deflationary’ today even though consumer prices have yet to deflate on a year-over-year basis. Those ‘recessionary’ conditions of a year ago, with their normal lags, have morphed into a contraction in real GDP today. In a similar vein, the current ‘deflationary’ backdrop will very likely morph into outright CPI deflation next year. This is one of the major stories that will emerge next year and, in our view, dominate the financial market landscape."

His estimates suggest that inflation will drop below 1.1% – its lowest rate to date – in the second quarter of 2009 as the result of falls in gold and other commodity prices, growing US job losses, and reductions in personal debt levels.

Rosenberg says deflation can become self-perpetuating: "Deflation, like runaway inflation, can be self-perpetuating insofar as consumers defer expenditures in expectation of further discounting and this delay itself reinforces the discounting trend by putting downward pressure on domestic demand. Likewise, firms that are faced with deflation to their top-lines are typically forced to cut costs to protect their profit margins and in so doing, trigger a second-round negative income effect on their workers and suppliers, which also ends up exacerbating the trend towards lower pricing."

Morgan Stanley economist Richard Berner, who is based in New York, wrote on Wednesday: "Deflation fears are suddenly rising, as the full impact of the credit crunch hits markets and economies.  Small wonder: Plunging commodity prices, crumbling inflation expectations, a soaring dollar, and the onset of a potentially severe global recession are combining to reverse the inflation spike of early 2008.  The reversal has been abrupt; only three months ago, the sharpest global inflation surge in more than a decade galvanized many central banks into tightening monetary policy. 

Measured by the IMF’s global composite, consumer prices accelerated to a 6.8% clip in the year ended July, more than double the rate 18 months earlier.  Now it’s becoming fashionable to argue that deflation will supplant inflation as a key threat to markets and the economy.  We disagree.  In our view, inflation will decline significantly over the next several months and headline inflation could temporarily turn negative in the US and in other industrial economies.  But deflation − a general, ongoing decline in prices − is unlikely."

Berner says: "Similar to five years ago, four ingredients likely rule out deflation.  First, it’s critical to remember that the current inflation decline largely represents a reversal of the inflation spike of early 2008, rather than ushering in a new era.  In fact, it may seem bizarre to discuss deflation now when inflation was a dominant worry this summer.  So far, there’s scant sign of deflation in any price measure or in inflation expectations.  Although headline prices likely will decline sharply in coming months, underlying inflation over the past three months is elevated at between 2.7% and 3.3%.  Surveys of one-year ahead inflation expectations are still over 4%. 

Second, we think companies will quickly cut excess capacity to balance supply with demand.  Unlike in the 1990s, corporate capital discipline has restrained industrial capacity growth to less than 1% annualized over the course of the current expansion, or one-third the historical average.  Coming cuts in capital spending should quickly tame the emerging excess .  Third, some of the emerging global declines in goods prices are clearly declines in relative prices, not prices generally.  They are a boon to consumers; the plunge in US retail gasoline prices alone from a peak of $4 gallon in July to below $3 will be the functional equivalent of a $150 billion tax cut for consumers − and more if prices fall to $2.25, as seems possible.  Indeed, this shift in the “terms of trade” benefits consumers and most businesses, even in commodity-producing countries .  And most important, the Fed is easing aggressively and now quantitatively to influence inflation expectations."

Deflation: Making Sure "It" Doesn't Happen Here - - Fed Governor Ben Bernanke in 2002.

Preventing Deflation: Lessons from Japan's Experience in the 1990s  - - Fed paper by Alan Ahearne; Joseph Gagnon; Jane Haltmaier; Steve Kamin

Irish economist Dr. Alan Ahearne is now based at NUI Galway, Ireland.