Deflation Fears: Memories of Japan in the 1990's

A Conversation Starter

By: Lou Brien

“Ahem…excuse me…pardon the interruption, but we think we smell smoke. I’m sure there’s no cause for alarm, yet it would be prudent for us to sniff around a bit in order to determine if that old adage about there being fire in the vicinity of the smoke rings true. Don’t misconstrue, we don’t know that there is fire, but be informed, we don’t actually need to see fire before we call out the bucket brigade, all we need is to see or smell more smoke.”

The FOMC made an important addition to the paragraph that deals with inflation in their most recent post meeting statement. For several months they have assessed inflation thusly; “With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.” But in the statement they released last week they preceded that sentence with this one; “Prices of energy and other commodities have declined somewhat in recent months, and underlying inflation has trended lower.” This new twist on the inflation story is a conversation starter for the possibility of the Fed taking another stab at extraordinary easing of monetary policy. Not to say that the Fed has committed itself to such a strategy, but a continuation of the downward trend in price measures, not actual deflation but just a step or two lower, will bring a reaction from the Fed and remember, they can’t lower the funds rate any further.
That inflation is quite low is not a revelation to any financial market participant; the CPI Core is, at +0.9%, the lowest it has been in forty-nine years. Nor is it a mystery that the Fed has little worry for a near term rise in prices; at the April FOMC they sharply lowered their outlook for the level of inflation at the end of this year. The interesting thing is that they have made public their concern that “underlying inflation has trended lower.” I describe it as a concern because a further decline from an already low level would put inflation inside the comfort zone; too close to zero. Former Fed boss Greenspan cautioned against such a thing back in 2003 when he suggested that the Fed needs “a wider firebreak” in order to contain deflationary forces that would build intensity should the inflation rate approach zero. Current chairman Bernanke described it as a “buffer zone” in a speech about deflation that he delivered in November 2002; “Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero.” Well, the nominal rate is already at zero and that means that should the Fed see the need to counter an unlikely but possible occurrence of deflation they will have to use other methods. “Sustained deflation can be highly destructive to a modern economy and should be strongly resisted,” said Bernanke in his 2002 speech on the topic and he concluded that “prevention of deflation” is preferable to the cure.
If the Fed were to bet they would probably place their money against a deflationary episode. But a hugely influential paper that was presented to the Fed at the June 2002 FOMC meeting urged caution about such an unhedged gamble. The paper, “Preventing Deflation: Lessons from Japan’s Experience in the 1990s”, concluded; “First, notwithstanding the severity of the collapse in asset prices and the vulnerability of the financial sector to this collapse, Japan’s sustained deflationary slump was not anticipated. This was true not only of Japanese policymakers themselves, but also of private-sector and foreign observers, including Federal Reserve staff economists. Two-year ahead forecasts of GDP growth and inflation by both Federal Reserve staff and the Consensus Economics survey, for example, remained well above actual growth and inflation rates until the second half of the 1990s. Moreover, financial markets had no better handle on the economy’s prospects; long-term bond rates remained as high as 5 percent right up until the start of 1995. The failure of economists and financial markets to forecast Japan’s deflationary slump in the early 1990s poses a cautionary note for other policymakers in similar circumstances: deflation can be very difficult to predict in advance. In consequence, as interest rates and inflation rates move closer to zero, monetary policy perhaps should respond not only to baseline forecasts of future activity and prices, but also to the special downside risks-in particular, the possibility of deflation-to those forecasts as well.” (Bold face type was added by me.)
In other words when it comes to the possibility of deflation it is better to be safe than sorry.
The Fed has, of course, already done a lot. They took the funds rate down to a range that includes zero as its lower boundary, they have tripled their balance sheet through a trillion dollar plus expansion of the Monetary Base and, by any other name, they have dabbled in quantitative easing, buying one and a half trillion worth of Treasuries and mortgage products; all of which were ideas that Bernanke made mention of or hinted at in his 2002 speech on making sure deflation doesn’t happen here. And yet, even with those efforts, the level of inflation remains quite low and underlying inflation has been trending lower. The Fed said as much in their latest FOMC statement and I think they said so for a reason. I think they wanted to open up the topic to discussion; they may not be ready to act on it now, but there is a limit to how low inflation can go without a policy response.
It is well known that Bernanke is a student of the Great Depression and that he is well studied on the Japanese experience of the 1990s, he is very familiar with the problems that would ensue should deflation gain a foothold. Therefore, one should not expect him to sit idly by if the inflation measures slide much further from here. But much has been tried and none of it has reversed the underlying downward trend of inflation. What do they do next should they feel the need to do something more? It is possible that Bernanke borrows once again from the 2002 deflation speech and maybe tries to “stimulate spending by lowering rates further out along the Treasury term structure.” He mentions a few different ways to accomplish this but he definitely has a favorite. “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest rate ceilings by committing to make unlimited purchases of securities up to two year from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well. Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years.”
There is no saying if this is what they will try next should they need to try something more, but it is reasonable to assume that something like that will have its place in the conversation. It is also reasonable to assume that at the very least the conversation has started.