The Consumer Price Index, a key inflation reading, fell 1.7% last month, according to the Labor Department. That was much weaker than October's 1% drop and exceeded the 1.3% decline forecast by a consensus of economists surveyed by Briefing.com. Prices fell by the greatest amount since the Department of Labor began publishing seasonally adjusted changes in February 1947. Though falling prices may seem like a good thing for consumers, deflation is generally bad for the economy. If prices fall below the cost it takes to produce products, businesses will likely be forced to cut production and slash payrolls. Rising unemployment would cut demand even further, sending the economy into a vicious circle. Deflation usually represents a system-wide contraction in demand, with consumers waiting on the sidelines as they wait for prices to decline even further. Economists expect more drops in consumer prices for several months, but most say deflation is still a long way off. Deflation usually represents large, sustained drops in consumer prices, but so far the economy has only recorded two consecutive declines. "It's a bit premature to say we're in a period of deflation," said Anika Khan, economist at Wachovia. "We've had two months of record declines, [and] deflation may be a far-off worry if that continues."
Is it really premature to worry about deflation? Then why is the yield on inflation indexed government bonds for 5-year and 7-year maturities higher than the yield on their nominal counterparts?