The following article by a group of Federal Reserve economists attempts to come to grips with any connection there may be between Japan's burst bubble and the creeping deflation they are experiencing.
Abstract: This paper examines Japan�s experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines toward zero. Is it possible to recognize when an economy is moving into a phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan�s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities� failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan�s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.
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This paper is well argued and to the point. Of particular note are the repeated failures of all the standard forecasting outfits to see what was going to happen, they consistently overstated the short term growth possibilities (any bells ringing here?). The problem with forecasting is that it assumes that the future is going to be a re-run of the recent past, and sometimes, as we can see, it isn't like this. Another point that is clear is the 1995 before and after situation - is it just a coincidence that the US equity market boom really got going post 1995?
Equally it is chastening to note that the real problem only became apparent five years after the equity bust. Again they indicate the difficulty of making a determination of whether or not an economy is entering a deflationary phase. For just this reason it's very difficult to look at the progress of the US CPI over the last years and say que si or que no. We could be on the way in, but again we could not. The recent fall in the US dollar is one positive note for the US here - but for the US, not the EU! In the end if the majority of economists don't envisage a deflationary panorama it's because looking at the recent past it seems a safer bet not to. But this is no guarantee.
Perhaps the most important individual lesson they draw attention to is the change in risk weighting that is appropriate when there is a wiff of deflation in the air. The risks become asymetric. The downside risks of deflation are much greater than the upside inflationary problems, and policy should be formulated accordingly. I'll let Stephen Roach have the last word here:
The Fed paper makes it quite clear that just the risk of deflation in a nation�s aggregate price level should be sufficient to trigger aggressive reflationary policies. The popping of a major asset bubble at low levels of GDP-based inflation -- precisely the case in the United States -- only serves to underscore those very risks.
For that reason alone, the conclusions of this Fed research paper seem quite relevant to me in assessing the prospective stance of the US monetary authorities. The Fed staff argues that the Japanese authorities should have been more aggressive in pursuing monetary easing and fiscal stimulus. In effect, they waited until it was too late. In large part because of that delay, the Fed researchers also found that the effectiveness of Japanese stabilization policies was diminished in the post-bubble climate -- with the authorities basically "pushing on a string" as Japan became mired in a liquidity trap. Under those conditions, the Fed staff concluded, the risk of a policy blunder that might otherwise seem to be overly stimulative need not be taken seriously. It can always be corrected once the deflationary alert ends.
We tend to cavalierly believe that America is not Japan. And, of course, in many critical respects the comparisons are wide of the mark -- especially when a functional US banking system is compared with its dysfunctional counterpart in Japan. But the Fed paper argues persuasively, in my view, that just as it was the case in Japan, it�s not worth taking deflationary risks in a post-bubble US economy. This speaks of a Fed that will remain predisposed toward monetary accommodation for some time to come.
Source: Morgan Stanley Global Economic Forum
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