Japan Deflation

Deflation returns to Japan. Tyler Cowen has a thoughtful Marginal Revolution post, expressing puzzlment. Scott Sumner discussion here, and Financial Times coverage.

Let's look at the bigger picture. Here is the discount rate, 10 year government bond rate and core CPI for Japan. (CPI data here if you want to dig.)

If you parachute down from Mars and all you remember from economics is the Fisher equation, this looks utterly sensible. Expected inflation = nominal interest rate - real interest rate. So, if you peg the nominal interest rate, inflation shocks will slowly melt away. Most inflation shocks are individual prices that go up or down, and then it takes some time for the overall price level to work itself out.


The recent experience looks a lot like 1998. As of 2001, it would have been reasonable to think that the dreaded deflationary vortex was going to break out. But it didn't. Inflation came trundling back. As of 2008, you might have thought that low rates would finally spark inflation. But they didn't. In 2014-2015 you might have thought that the latest in a 20-year string of fiscal stimuli, bond purchases, bridges to nowhere and xx-onomics programs were finally going to produce inflation. But, so far at least, no.

It's tough to make predictions, especially about the future,  as the late great Yogi Berra reminds us. Still, this is the third strike.

The long term bond market continued its linear trend throughout the recent episode, a strong sign that expected inflation had not moved. And the sharp jump up and then back down again exactly a year later smacks of data errors, or one specific component. I hope a commenter has more patience for wading through the data than I do to find it. 

To be sure, Tyler emphasizes a central puzzle. Even if you accept the view that the Fisher equation is a stable steady state, that ties down expected inflation, but not actual inflation. There are troublesome multiple equilibria. The fiscal theory of the price level can tie down one equilibrium in theory, but not yet in practical application. But I wonder if we're not overblowing this problem. If we interpret the shocks not as shocks to individual prices that take time to melt away, but as expectational shocks, we still get a pretty good view of the data. Nominal interest rates plus a slowly time-varying real rate tie down expected inflation, little multiple equilibrium shocks let actual inflation vary, but such shocks melt away.

And the earthquake fault under all of this: Even the theory that says pegs can be stable warns they can only be stable if bond investors think they will be paid back. At some point -- 250% debt to gdp, slow growth and no population growth? 300%? What does it take? -- they change their minds. And then Japan gets the inflation it has so long desired, and a bit more to boot.

In the meantime, perhaps rather than worry-worry, we should celebrate 20 years of the optimum quantity of money, achieved at last.

Update David Beckworth on the same topic. I'm less of a NGDP target fan. It's like saying all the Chicago Cubs need is a "win the world series" target. OK, but what do you want them actually to do differently? What 3 trillion of QE wasn't enough, but 6 will do the trick? I know the answer, that talk alone tweaks some off equilibrium paths to generate more "demand" today. And monetary policy does seem to be just talk these days. But still... I'm also less of a fan of looking at monetary aggregates. At zero rates, money = bonds, and MV=PY becomes V = PY/M.  But it's a well stated analysis in these terms, and nice coverage of the fiscal theory at the end.