What is the cause of Japan's ongoing deflation? Can a theoretical framework explain these developments? If so, can the Bank of Japan (BOJ) "create inflation at will" as many have argued?

The country has suffered from deflation for five consecutive years, measured by the consumer price index (CPI), and low inflation for almost a decade.  On a QoQ basis, Japan's headline series indicates a deflationary downtrend for 18 consecutive quarters, whereas "core" inflation (i.e., CPI excluding fresh food) has showed a smaller rate of decline in the past three quarters. However, this "core" deceleration was mostly due to inflationary changes in the cost of education, personal care services, cigarettes, and other miscellaneous items. Other categories, such as utilities, housing, household utensils, clothing and medical care have  shown smaller decreases.

Declines in the GDP Deflator, considered to be a much broader measure of goods and services in Japan, have been much steeper. In 1Q 2004, the GDP deflator fell 2.6% YoY, bringing its deflationary downtrend to 24 consecutive quarters. The rate of decline was almost unchanged from 4Q 2003, when it was -2.7%.

The Theory

What is the cause of Japan's on-going deflation and mild-level inflation? Monetarists, led by Nobel Laureate Milton Friedman, argue that "inflation is always and everywhere a monetary phenomenon"—something that is directly controlled by the central bank (in this case the BOJ) through a "stable"  monetary policy using open market operations¹ . 

The theory behind what impact open market operations may have depends largely on one's interpretation of why we hold money in the first place. One famous theory is expounded by John Maynard Keynes' liquidity preference theory. According to Keynes, people hold money for more than just transactions (the classical view); they hold it for speculative reasons. The three panels below  illustrate how the BOJ's open market purchases should theoretically affect interest rates,  loanable funds, output—and by extension, prices. Empirical findings will follow the theory² .

The left panel shows how monetary policy works through an open market purchase, where an initial equilibrium  at point "i₀," the nominal interest rate, exists for the demand and supply of money ("D" and "S₀", respectively).  If the BOJ were to conduct an open market purchase (i.e., quantitative easing), government bonds, bills or repos are purchased with the BOJ's created cash; the nominal quantity of money injected into the economy, therefore, increases; and the left panel shifts to the right from "S₀" to "S₁." Assuming the demand for money (liquidity) remains unchanged, the nominal interest rate (the price of money) should fall from "i₀" to "i₁" as the general public will be prepared to hold less in bonds (now held by the BOJ) and more in cash. Supply (money) exceeds demand (interest, bonds), so nominal interest rates (and bond yields) should theoretically fall.

Once the BOJ purchases these bonds, the cash received by the public tends to be deposited in the banking system.  This increases the reserves of the banking system and, through the deposit expansion multiplier, increases the supply of loanable funds in the Japanese economy. This is depicted in the middle panel as rightward shift of the supply curve for loanable funds from "S₀" to "S₁." If the demand for funds remains unchanged, real interest rates should decline from "i₀" to "i₁."

As real interest rates decline, real aggregate demand is stimulated in three ways: (1) by current investment and consumption becoming cheaper relative to future spending , thereby inducing a short-term catalyst; (2) by lower real returns (yields) on financial assets removing incentives for foreigners to invest in Japan, which, in turn weakens (depreciates) the Japanese yen, thereby stimulating exports; and (3) by asset values rising to produce a "wealth effect" that stimulates more spending on goods and services (the bond, stock, and housing markets respond favorably.)

This increased demand for goods and services moves the aggregate demand curve in the far right panel to shift upward from "AD" to "AD₁." If the BOJ's bond purchases (monetary easing) was not anticipated by the public, the short-run aggregate supply curve, or SRAS, will not change. Consequently, the economy will expand along the SRAS curve as real GDP and employment increases from "Y₀" to "Y₁," and the general price level increases from "P₀" to "P₁." Put differently, as the economy expands, so does the demand for goods, services and resources; demand exceeds supply, and therefore prices will go up (inflation).  

This theory is the more extended monetarist principle first expounded by economist Irving Fisher. Known as the quantity theory of money, MV=PY—money (M) * velocity (V) = prices (P) * output (Y). If you raise M, then P will rise too. And since prices (P) are linked to nominal GDP (Y), if you raise M you also raise Y ³ . Simple.  

The Evidence

Or is it? Should basic monetary theory prove correct, Japan's so-called "lost decade" of deflation, declining demand, rising unemployment and low output could (and should) have been corrected with an aggressive, but clearly stated, monetary policy by the BOJ.

What happened?

The facts show that the BOJ has lowered discount rates (collateralized overnight call rates) from a post-bubble high of 8.3% in March 1991 to virtually zero in June 2004. It has also begun, somewhat belatedly, an aggressive quantitative easing of its so-called high-powered money, or base money, in the 2000-2002 period (see chart below). The latter move forced nominal interest rates to fall completely to zero by 2002. Since then, annual base money growth slowed down further in June 2004 (3.2%), marking the fourth consecutive month of deceleration. Growth rates of both the current account balance and bank notes continued to decelerate as well; annual growth of bank notes fell to 1% yoy in June 2004 for the first time in 13 years.

Japan faces a "liquidity trap," where short-term nominal discount rates are zero, but people continue to hoard money rather than consumer or invest. Against this backdrop, the BOJ argues that it does not have the necessary instruments to achieve inflation in the current liquidity trap environment.

It certainly looks that way.

As we mentioned earlier, theory dictates that any expansion of the monetary base should lead to money multiplier affects. In other words, by purchasing government bonds the BOJ and the general public (via city and regional banks) enter into an agreement to increase the BOJ's reserves, to increase deposits of the banks for which loanable funds become available, which in turn should re-enter the bank through more bank deposits by the loan applicant, and so forth. But empirical evidence demonstrating this theory has produced mixed results.

There has been very little significant impact on the growth of broad money (M2+CDs) or the broadest liquidity (M4+CDs)—largely considered to be representative of the "money supply" in Japan. As the chart below indicates, although growth of broad money did pick up slightly in 2001, the move basically reflected a shift out of postal savings deposits because of the maturation of long-term teigaku deposits, and this effect has since passed. This is a clear departure from the 1980s and early 1990s, when the correlation with base money was much tighter. Since 1993, the growth rates have progressively decoupled.  

Consequently, the money multipliers, with respect to both M2+CDs and M4+CDs, have fallen steadily since the mid-1990s (see chart below). Money multipliers no longer "multiply."

Chance of Re-Inflation

As Figure 1 indicated, there is a sizeable disconnect between the CPI and the GDP deflator in recent months. While both are still in negative territory, both indexes tended to move in unison throughout the 1990s. If there is a chance of re-inflation, does the market anticipate it? And how does the BOJ react to this information?

Many critics of the BOJ have argued that it should adopt an explicit inflation target. This would involve specifying a target range for the inflation rate and a time period for achieving the target. Countries such as Australia, New Zealand, the UK and Canada are all currently employing such targets.  

As I already mentioned, the BOJ has consistently counter-argued that it does not have the necessary instruments to achieve an inflation target in the current liquidity-trap environment with a floating-exchange rate regime. Rather, it has "committed" itself to maintaining its current policy stance of quantitative easing until prices have turned "positive" as measured by the core CPI—although BOJ Governor Fukui's meaning is unclear in this instance. What does "positive" mean? How long must prices remain "positive" before policy changes? In what form will this change of policy take?  

This lack of commitment clarity has overshadowed the actions of the bond market. The questions is: does the market believe inflation is forthcoming? 

The chart below plots Japan's CPI against various decomposed JGB yield curves. The theory is that bonds of different maturities are substitutes, although not necessarily perfect substitutes; the investor may need an incentive (read: higher interest rate) to part with his/her money for longer maturities. Inflation risk erodes the purchasing power associated with such initial bond payments⁴ . The ensuing "yield curve" demonstrates this principal by telling us about the public's expectations of future short-term interest rate movements, and by extension, inflation risk⁵ .

Recent bond market movements suggest either a belief in the BOJ's commitment to price stability or an optimistic view that inflation is around the corner, depending on the time-frame. A steeply rising yield curve, say, from May-October 2003, suggests that short-term interest rates are expected to rise. At its low in May 2003, a 10-year JGB had a yield 0.54 percent (its lowest in recent years), while a 5-year JGB and 2-year JGB had yields of 0.16 percent and 0.05 percent, respectively. Effectively, the market continued to believe that the BOJ's current "wait and see" policy of inflation through quantitative easing would take place. By October 2003, 10-year JGBs had risen to 1.46 percent and 5-year and 3-year yields had risen to 0.64 percent and 0.155 percent, respectively. These yield increases imply not only the possibility the BOJ would slow monetary easing (so-called tightening), but rather quickly judging from the 48bps (5-year) and 10bps (2-year) moves of the JGBs!

However, post-October 2003 yield slope movements (moderately steep vs. very steep yield curves) suggest that the market is no longer sure that inflation is imminent. If anything, deflation may persist.   

Why Deflation Persists, The Theories

What has gone wrong? Why does the market believe that deflation may persist? There are several competing theories. First, the direct link of base money growth to bank lending via the reserve requirement (see The Theory) clearly is not working. Money multipliers are not "multiplying.": Obviously, the sheer size of predicting outcomes in the whole economy is different from any  agreement one may find among micro-economists. Still, several economists have floated  theories as to why the assumptions behind the affects of monetary policy have yet to deliver inflation. The top-5 post hoc explanations include:

(1) Nominal interest rates may be zero, but there are few profitable investment opportunities in post-bubble Japan that could induce businesses to borrow or banks to lend. Structural reform and deregulation are needed. Richard Katz has adopted this view.

(2) Nominal interest rates may be zero, but real interest rates (nominal interest rate minus rate of inflation) are still hindering growth. The BOJ needs to announce a inflation target and print enough money to meet such expectations in order to meet such a general price target. Paul Krugman has expressed this view. 

(3) The disconnect in growth between M1 (currency + deposits) and M4 (broad liquidity) indicates a malfunction in the transmission mechanism. The BOJ may have expanded the money base in the 2000-2002 period, but the monetary easing was not aggressive enough. Some Tokyo market economists have expressed this view.

(4) Deflation is the result, not the cause, of a spiraling market psychology aimed at cleaning-up highly leveraged balance sheets. No level of monetary easing or inflationary targeting will convince businesses to use their free cash flow for investment rather than debt-reduction. Richard Koo has expressed this view.  

(5)  Nominal zero interest rates cannot expect to be helpful if bad debt prevents banks from lending and if the central bank does not increase its credit creation to compensate. For bank credit creation to rise, banks' risk aversion needs to be lowered. This can be achieved if the central bank were to conduct a one-off write purchase operation of all declared bad debts from the banks at their original book value. Richard Werner has expressed this view. 

Notes

1. Milton Friedman's famous 1956 article, "The Quantity Theory of Money: A Restatement" expanded upon both Irving Fisher's quantity theory of money (i.e., M*V=P*Y) and John Maynard Keynes's liquidity preference theory. The reason people hold money, Friedman argued, were the same reasons why people demand any asset. His theory, known as the portfolio choice to money, indicated that the demand for money should be a function of the wealth of the individual and the expected returns on other assets relative to the expected return on money. However, unlike Keynes's theory, which indicates that interest rates are an important determinant of the demand for money, Friedman's theory suggests that changes in interest rates should have little effect on the demand for money. Why? Because, in Friedman's view, any change in expected interest rates effect not on the expected return on money, but also on other assets as a result of the expected return on money.

2. In effect, the ISLM model is the more sophisticated exposition of the Keynsian liquidity preference theory discussed here.  It was invented by Sir John Hicks in a famous 1937 article, "Mr. Keynes and the Classics."

3. The difference is that Keynes abandoned the classical view that velocity was a constant. This was probably a wise move considering that the classical monetarist belief in the stability of velocity is not borne out in the Japanese data; in fact, the velocity of money (i.e., GDP ÷ the money supply) has been terribly unstable since the 1970s.

4. For example, if a risk-free 10-year JGB has a coupon rate of, say, 2.8 percent, and prices increase at the rate of 1 percent p.a., the investor's real rate of return will be 1.8 percent. A higher expected inflation rate results in a further reduction in the purchasing power of bond payments, thus lowering the demand for bonds. In order to protect one's investment portfolio, all else being equal, the bond holders will sell their positions in favor of newly issued bonds with (hopefully) higher interest rates (As bond prices fall, interest rates rise. This is the so-called "Fisher effect.")

5. The "yield curves" in the accompanying chart are nothing more than the graphic representation of the so-called "absolute yield spreads," or yield differentials, that exist between JGBs of different maturities.

Essay first published June 23, 2004.

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