Deflation

Core inflation rates are still headed downward:

[source]

A recent Economic Letter at the San Francisco Fed examined the Phillips curve relationship between inflation and unemployment, and used that model to forecast inflation through the end of 2010:

For the period from the fourth quarter of 2009 to the fourth quarter of 2010, the Phillips curve model suggests that inflation should continue to go down and remain low, as the unemployment rate is likely to remain high.

This leads to a puzzle: Why don't the consensus macro forecasts show much of a fall in inflation? If current unemployment forecasts are right, inflation should continue to fall. And the graph above gives no reason to doubt that forecast (e.g., note how long the downward trend in core inflation persisted after the last two recessions). Do forecasts of inflation invoke some magical "anchoring" effect to say that somehow this won't happen?

Maybe there's another reason. The Economic Letter linked above suggests that the Phillips curve may only operate in severe recessions:

The issue of whether the Phillips curve is useful for understanding inflation behavior has figured prominently in monetary policy discussions, with Federal Open Market Committee (FOMC) members expressing opposing views. The following quote from the FOMC minutes in August 2009 reflects this disagreement:

Most participants anticipated that substantial slack in resource utilization would lead to subdued and potentially declining wage and price inflation over the next few years; a few saw a risk of substantial disinflation. However, some other participants were skeptical that temporarily low levels of resource utilization would reduce inflation appreciably, given [the] loose empirical relationship of economic slack to inflation and the fact that the public did not appear to have reduced its expectations of inflation.

...We argue that, in a deep economic downturn such as the current one, inflation and unemployment do tend to move together in a manner consistent with the Phillips curve. But, outside of such severe recessions, fluctuations in the inflation and unemployment rates do not line up particularly well. ... This explains why some studies find only a "loose empirical relationship" between economic slack and inflation.

If there is a difference in the relationship between inflation and unemployment depending on the state of the economy, and if people form their expectations based upon data from normal times when the "loose empirical relationship" is operative, that could cause people to underestimate the change in inflation corresponding to changes in unemployment.

Any other ideas?