Wednesday, December 18, 2013

Why the US is not at risk of a Japan-style deflation

Concerns about the risk of a "Japan-style deflation" in the U.S. are once again heating up, as the Fed prepares to taper its bond purchases, something that's very likely to happen either this month or next. The worry—echoed in a front-page article in today's WSJ—is that tapering and eventually ending QE at a time when inflation is unusually low runs the risk of producing even lower or negative inflation (i.e., deflation), which in turn could doom the U.S. economy to very weak or even negative growth for the foreseeable future, much like the problems that have plagued the Japanese economy for many years. Without ongoing QE support, the thinking goes, the U.S. economy could fall into a sort of deflationary quicksand and/or lose all forward momentum. But is deflation really so dangerous, and has growth really been so dependent on QE?

I think these concerns are not only exaggerated but in fact groundless. For one, the U.S. is not even flirting with deflation. Second, deflation is not necessarily a bad thing and it does not necessarily lead to weaker growth. Japan's demographics have likely contributed more to its relatively sluggish growth than deflation has. Third, there is an important difference between the U.S. today and Japan of the past several decades that makes pervasive and crippling deflation in the U.S. economy very unlikely: the dollar has been and continues to be very weak, whereas the Japanese yen was extremely strong for decades. 

Finally, and as I've argued repeatedly in this blog, I don't think that QE policy was ever designed to be stimulative, and that's why it hasn't contributed to boost growth or raise inflation. Contrary to what central bankers all profess and the WSJ article repeats, namely that central bankers have been engaged in "unprecedented money-printing campaigns," there is no evidence of any unusual growth in the money supply. Put simply, the Fed has not been printing money with abandon. The Fed has simply been exchanging bank reserves, which are now close substitutes for T-bills, for notes and bonds. The beginning of tapering and the eventual end of QE is therefore not going to be contractionary or deflationary.

Let's begin by taking a look at inflation in the U.S. as measured by the Consumer Price Index.

The U.S. consumer price index registered a zero rate of inflation in November, but it is up 1.2% over the past year, and it has risen at an annualized rate of just under 2.4% for the past 10 years. As the first of the charts above shows, the CPI index today is only slightly below its 10-yr average growth rate. What we've seen in the past year is a modest slowing in the rate of inflation, but this is hardly a sign of impending deflation. As the second of the above charts shows, the weakness in the headline CPI owes a lot to falling energy prices: ex-energy, the CPI is up 1.6% in the past year. Plus, as the third of the above charts shows, over the past six months both core and headline CPI inflation have been running at very close to a 2% annualized rate. Bottom line: Inflation is relatively low, but it is not even remotely zero or negative.

It's a little-known fact, but if you're looking for evidence of deflation in Japan, you won't find it in their Consumer Price Index. At the consumer level, inflation in Japan has been essentially zero for the past 20 years (see chart above). The index has bounced around a bit along the way, but has trended neither higher nor lower since 1993.

Deflation only shows up in Japan's Producer Price Index and in the GDP deflator, the latter of which is shown in the chart above, and it didn't start until 1999. Since the end of 1998, the Japanese economy has experienced a 1.25% annualized rate of deflation: on average, prices across the entire economy have fallen by roughly 17% over the past 15 years. Deflation now appears to be ending, however, with consumer prices up 1.1% in the year ending October, and the GDP deflator down only 0.3% in the year ending September, thanks to a concerted easing effort on the part of the Bank of Japan which has resulted in a significant decline in the value of the yen. 

As the chart above shows, since the onset of deflation in 1999, Japan's economy has grown at a paltry 0.8% annualized rate, far less than the 2.1% annualized growth of the U.S. economy over the same period. It's tempting to lay the blame for Japan's sluggish growth on the doorstep of deflation, but that overlooks the role of demographics. Thanks to its rapidly aging population and low fertility rate, the Japanese workforce (the number of people working) has shrunk by almost 4% since its 1997 peak, even as the unemployment rate declined to only 4%. Contrast that to the almost 11% increase in the U.S. workforce over the same period (which has actually been much slower than is typical), and you see that the U.S. has had the benefit of a 0.9% annualized increase, relative to Japan, in the number of people working. That could explain as much as 70% of Japan's growth shortfall relative to the U.S. Deflation, in other words, is likely only a small part of Japan's slow-growth story. When the number of people of working age declines, it's hard for an economy to grow. Japan's total population, by the way, is already declining, and is expected to fall by 3% within the next 5 years relative to its high, which was 5 years ago. The U.S. population is expected to grow by 6.5% over the next 5 years, so the disparity between Japanese and U.S. growth could become even more pronounced. 

The talk about Japan's deflation and slow growth has been with us for years (I had a post on this same subject back in May '11) so it's easy to be lulled into thinking that deflation necessarily results in slow growth. The popular argument goes like this: when consumers realize that their money buys more every year, they are less likely to spend, since saving—even with very low interest rates—becomes an attractive way to make money. For their part, borrowers soon learn that when prices fall it becomes harder to generate the cash needed to service debt. Deflation thus acts to depress borrowing and spending, and a shortfall of demand is what causes growth to be weak. 

In reality, it's not as simple as that. Deflation is not necessarily worse than inflation. What hurts an economy is when inflation turns out to be very different from what people expected. Persistently high inflation (such as that suffered by Argentina in the 1970s and 1980s) can wreak havoc in an economy, but it doesn't rule out growth. Lots of inflation is bad because creates uncertainty and high interest rates, which in turn make it difficult to make long-range plans. On a more mundane level, while deflation may cause some consumers to cut back on their purchases in order to acquire more goods and services in the future, other consumers discover that deflation has increased their purchasing power and their standard of living. Borrowers don't necessarily suffer from deflation either; when inflation becomes very low or negative, interest rates invariably fall to very low levels as well. Real interest rates—the true measure of the burden of debt—are actually about the same in Japan as they are in the U.S. Using GDP deflators, for example, the real yield on 10-yr JGBs today is about 1.1%, while the real yield on 10-yr Treasuries is about 1.3%. 

One last observation: As a rule of thumb, inflation benefits borrowers, while deflation benefits savers. Arguably, it's better to have motivated savers (the source of the capital needed to fuel productivity-enhancing investment) than motivated borrowers (especially the type that just want to speculate on higher prices). 

Let's now take a look at what is most likely the proximate cause of Japan's long bout of deflation: the significant and long-lasting appreciation of the yen.

Beginning in the 1970s, the Bank of Japan adopted such an austere approach to monetary policy (restricting the growth of the money supply) that the yen appreciated against other major currencies for the next 35-40 years. Demand for yen simply outstripped supply. A chronic and relative shortage of yen drove its value up from from 350 to the dollar to as strong as 76 to the dollar in late 2011, and from 250 to the euro (using the DM as a proxy) to less than 100. That's appreciation by a factor of 4.6 times against the dollar, and 2.5 times against the euro. 

The steady appreciation of the yen forced Japanese exporters to cut their prices in order to remain competitive, and it forced domestic-oriented companies to cut their prices as well, in order to compete with an ever-cheaper flood of imports. As a result, Japanese inflation was significantly lower than that of most other major economies for over 35 years. This fact is reflected in the upward slope of the green line, which is my estimate of the Purchasing Power Parity of the yen. The slope is upward because the Japanese price level rose by much less—and more recently fell—compared to the price level of other industrialized economies. 

While the yen was surging against the dollar and the euro, the dollar was falling against almost all major currencies, as shown in the chart above. U.S. exporters have not faced the downward pricing pressures that Japanese companies have had to deal with for decades.

Even after adjusting for relative inflation differentials, the real value of the dollar today is very close to its weakest ever, as shown in the chart above. U.S. companies have not been forced to continuously cut costs and prices like their counterparts in Japan. This is a "night and day" difference which could explain at least part of the reason that Japan's economy has been relatively weak. From a fundamental point of view, the U.S. economy has not been subject to the relentless deflationary pressures from abroad that have plagued Japan. On the contrary, inflation and a weak currency have been the norm for the U.S. ever since the early 1970s, whereas it has been just the opposite for Japan.

I think all of this adds up to a powerful argument for why there are no useful parallels between the U.S. and Japan when it comes to the risk of deflation and slow growth.

Looking ahead, there is one thing that has really changed on the margin, and that is the yen's significant decline over the past year. As the chart above shows, the decline of the yen has corresponded tightly with the rise of the Japanese stock market. This provides confirmation for my thesis here, which is that the appreciation of the yen beginning in the late 1990s was symptomatic of overly-tight Japanese monetary policy which proved to be a burden on the Japanese economy. Now that Japan has apparently succeeded in fundamentally relaxing its monetary policy, the prospects for the Japanese economy have brightened.

Why then has U.S. inflation remained low and slowed of late if the Fed is doing all it can to keep interest rates low? I fleshed out the answer to this question in a post earlier this month: it's because we have been experiencing the most risk-averse recovery ever. Risk aversion and a general lack of confidence have translated into very strong demand for money and bank reserves. This is not likely to get worse, and the decline in gold prices and the rise in real interest rates suggests that confidence is slowly returning and risk aversion is beginning to decline. A gradual decline in risk-aversion and a gradual increase in confidence cry out for the tapering and eventual reversal of QE. In the meantime, there is no evidence to suggest that the Fed has burdened the U.S. economy with overly-tight monetary policy, because the dollar has been and continues to be weak.

The U.S. economy is not condemned to nor at great risk of a future of deflation and slow growth.

2 comments: said...

It's interesting, the Japanese experience. It in no way resembles the U.S. experience.

They have a number of factors that are holding it back, relative to, say, the U.S., including the following:

Highly resistant to opening their agricultural markets to foreign goods. So the Japanese consumers are overpaying for foodstuffs.

Retailers are inefficient in size and scope compared to the U.S. The U.S. retail machine is much more efficient in delivering goods to their customers than are Japanese retailers. Once again, the consumer is spending more to get the same amount of goods as do we.

Japan restricts companies from setting up shop in Japan more so than do we. Witness the trouble that an American investor is having in proposing an investment in, and 'breaking up' Sony into several pieces. Sony has been out of the 'leading edge' of innovation and product development for a number of years. By the U.S. being relatively open to foreign operation setting up here, compared to Japan, it brings more dynamism to our economy, compared to that of Japan. Their economy is highly sclerotic in contrast.

We are 'solving' our declining birthrate 'problem' by allowing immigration, legal or otherwise. Japan is not an open to immigration destination relative to the U.S.

I agree, the comparison of the Japan deflationary experience as a foreshadowing of U.S. future price level and GDP experience is a non-starter.

Benjamin said...

Well, count me in the tight-money-caused Japan's perma-deflation-recession, and turned them into a backwater nation, vs. the booming China, which has had a non-independent accommodative central bank.

The break in the Japan success story happened suddenly in 1992, when the Bank of Japan shot for zero inflation, in an over-reaction to nearly 20 percent inflation in the very strong growth years.

Only after 20 years did people start saying demographics, or retailing, or regulations---in fact, in the glory days, it was all Japan Inc. and they their regs and government-private sector cooperation was a model for the USA.

Yes, the US Fed has reacted to recession in a better way than the Bank of Japan. That's like saying they played better than the 1962 Mets (yes, I am getting old).

I wish for Scott Grannis never to live a world of deflation---just what happens to real estate values in sustained deflation? Who will lend on a depreciating asset? Who will buy an asset worth less next year? And when lenders stop lending, what happens to real estate---it starts depreciating.

Japan real estate is down 80 percent from 1992, and never got better, and much the same story is told in their stock mart.

You want to lose 80 percent of the value in your property or stocks? Then gung-ho for deflation.