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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.

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