Wednesday, November 24, 2010

Thoughts on deflation

Fed governors have told us quite a few times this past year that they are extremely concerned about the possibility that the US economy might fall into a deflationary trap. They have explicitly stated that the current rate of inflation is "too low," below their target rate of inflation. In that context I offer the above chart, which shows the year over year change of the personal consumption deflator, the Fed's inflation measure of choice, since it is a broader and more dynamic index than the CPI.

The October reading on the PCE deflator was 1.26%, while the core version was 0.94%, slightly below the 1-2% target the Fed introduced some years ago. I note that both measures of inflation were above their target for about 5 years (2004-2008) without this triggering unprecedented action on the part of the Fed to bring it down. Is deflation really such a bad thing that the mere hint of it should justify the use of unprecedented quantitative easing measures? If I were on the Fed board, I would have been much more concerned about the upward drift in inflation earlier this past decade than about the recent downdraft.

To trot out the example of Japan, as many, including the Fed, are wont to do—where it is presumed that Japan's deflation has been the scourge of its economy for the past two decades—is not very constructive, since the differences between the U.S. and Japan far outweigh the similarities. To begin with, Japan's deflation is directly attributable to its monetary policy. The Bank of Japan has managed to keep money so tight for so long that the yen has appreciated against every other currency on the planet for many years. This appreciation is fully explained by the fact that Japan's inflation rate has been much lower than that of other major economies, particularly that of the U.S. The chart below shows how the yen's purchasing power parity (PPP) has risen steadily since the late 1970s, due to Japan's lower rate of inflation, and how the yen has basically followed that same path.

The U.S. has had no similar experience with monetary deflation, so there are no parallels with Japan. Furthermore, there is no reason to think that a mild deflation such as Japan has had should be the cause of two decades of disappointing growth. For one, Japan is unique among major industrialized nations in that its population is much older, and the growth of its labor force has been much slower (Japan's demographics have now resulted in a decline in its working-age population). Japan also has suffered from decades of extremely "expansionary" fiscal policy which has burdened the economy with a debt/GDP ratio of well over 100%. For my money, Japan's disappointing growth has much more to do with too much government spending (which is always very inefficient) than anything else. That's the parallel with the U.S. that makes sense to worry about.


Benjamin Cole said...

I concur wholeheartedly that federal spending, as fraction of GDP and as debt, should be curtailed. I can't understand why we do not shoot for 16 percent of GDP as the proper federal level of spending, not the 21 percent mentioned in the recent ballyhooed report.

That said, I think Japanitis is a real threat to the USA.

Milton Friedman said all inflations are monetary, so I guess it follows all deflations are monetary. We are in deflation now, by some measures (some suggest the methods for measuring inflation undercount true inflation).

Certainly, now is no time to worry about inflation--now is the time to stimulate the economy by any means necessary, including tax cuts, reg cuts, and a very stimulative monetary policy.

MF told the Japan Bank of Japan to print a lot more money in the 1990s. They did not listen--and they are still floundering.

Bill said...


Aren't you concerned about the fall in housing prices in both the existing and new home sales numbers?

Brian H said...

Great post Scott.
Also, what is your take on the significance, if any, of Russia and China leaving the dollar for their bilateral trade...

Public Library said...

Well said Scott. Bankers fear deflation because they cannot benefit from it as much as inflation.

Mild deflation is the natural result of technological innovation unless central banks prevent it by printing money.

There is nothing to fear. I would argue we should embrace it.

Happy Turkey Day all!

Scott Grannis said...

Brian: I don't see any significance in what China and Russia have decided to do with the dollar. Their decision to not use the dollar as an intermediary currency won't change the overall demand for dollars, since they would only hold the dollar briefly in their transactions in any event. This decision is not about whether they want to own dollars, it is just about whether they will use the dollar on a temporary basis in their transactions.

Scott Grannis said...

Bill: I think the Case Shiller data on housing prices is arguably the best one to follow, and it shows that prices have essentially bottomed. Whether they drop a little more or not is not very important at this point. The most important thing is whether the economy continues to grow or not. Growth will trump everything in the end. So far it looks Iike growth will continue, so I think other problems like housing will sort themselves out with time.

Bill said...

Thanks Scott. Have a happy Thanksgiving. And to you Marmico- try to have a happy Thanksgiving as well. I hope someone is nice to you today.

Charles said...

The notion that a nation can "fall into a deflationary trap" is amusing. The way to prevent deflation is to allow prices to fall and markets to clear. Specifically in the US we should be looking for ways to accelerate the foreclosure process.

But despite all the damage that government policy has done to the economy over the last 3 years, a PCE deflator growing at 1% is not deflation. It is nowhere close to a "deflationary trap." This would require markets to believe that prices will fall fast enough and long enough to make cash an attractive investment and that the fed would be powerless to stop it.

The lesson of Japan is that Keynesian "stimulus" and QE are no substitute for allowing institutions that are "to big to fail" to fail. The fundamental difference between the US and Japan is that their corporate sector was zombified along with their financial sector. So it will not take us 20 years to pull out of this mess.