Tuesday, November 15, 2011

Fed Study: Inflation? What about Deflation?

What Should a Central Bank do in the Following Situation?
A real estate bubble causes Foreign Portfolio Investment to flow into the country. Suddenly, the bubble bursts and the country's financial system collapses. The left blames lax financial standards, while the right blames an inflated money supply.  With all this in mind, the key question is….    What to do With Interest Rates and With the Money Supply?

Japan: Once Upon a Crisis
In early 1990, the Japanese asset price bubble (lit. baburu keiki) came to an end. During this period, Japan renounced currency price intervention and the subsequent bubble attracted foreign speculative funds on a massive scale, in proportion to Japan’s role as the world’s second largest economy (at that time). At the end of the bubble, asset prices and then economic growth declined dramatically. While the Bank of Japan did engage in monetary loosening, the consensus view in retrospect was that the BOJ’s monetary response was wholly insufficient. Stated otherwise, the response of the BOJ to the Japanese asset price bubble was too little, too late.

The BOJ’s policy response came slowly. In March of 1991, a year after the bubble burst, the BOJ’s policy rate was still at its high of 8.2%. This was gradually brought down to 2% in 1995. In 1993-94, there was a brief thaw in the Japanese crisis. This thaw served to dissuade the BOJ against further stimulatory action.

After asset prices collapsed in Japan and firms’ balance sheets deteriorated, interest in lending and borrowing from both the lender side and the borrower side had radically diminished. This in turn eroded the possible effectiveness of monetary action by the BOJ. In this respect, the BOJ missed the crucial opportunity to turn things around – for an entire year–.

This was exacerbated by a “wait and see” attitude adopted by the Ministry of Finance with regard to bank intervention, which persisted until 1997 when Japan’s government used fiscal policy to recapitalize the banks –seven years after the crisis began– . By 1995, Consumer Price Inflation was negative, despite the fact that interest rates were essentially at zero.

Unfortunately, deflation is a much more difficult phenomenon for central banks to remedy. Deflation strongly discourages both investment and consumption. After all, why would, one buy something today when it will cost less tomorrow? For that matter, why would one dare to invest in assets which will only have lesser monetary value next year? Furthermore, how can the central bank react to deflation? Given that deflation occurs during a recession, it certainly can’t solve anything by raising interest rates. In the other direction, interest rates can only be lowered as far as the Zero-lower -bound.

What it Means for us Today
The key lesson about Japan’s crisis, recession, liquidity trap, and deflation, is that if a central bank and an economy are to overcome large economic shocks, the reaction must be swift and it must be decisive. The consequences of hesitating during a crisis amount to exacerbating the crisis and triggering deflation, which is difficult to emerge from.

The Politicians Keep Getting it Wrong
One thing which has clearly emerged in the discourse in the US is conservative anger about the monetary expansionism of the Federal Reserve. On one hand, Herman Cain has proposed switching altering the Federal Reserve’s mandate from two goals – inflation stability and economic growth – to a mandate with the sole aim of inflation stability. On the other, ex-cargo pilot-turned Texas politician Rick Perry calls Ben Bernanke a traitor, ostensibly for not sinking in the US economy in the Japanese fashion.

The Federal Reserve Study
In 2002, the Federal Reserve published a study on the causes, effects, and consequences of the Japanese recession. The study comes to the conclusion that, considering the risks of liquidity trap, deflation, and the difficulty of emerging from the situation, both monetary and fiscal stimulus during a crisis situation should go far beyond conventionally established norms.
About the Author:
The Federal Reserve is the Central Bank of the Unites States of America.