The Nikkei Financial Daily (Market Eye Column)., 6th March 2006
Share prices on the Tokyo Stock Market have become much more volatile. Investors seem to be having second thoughts about deflation. Until recently, its expected demise was seen as bullish. The market is, however, now showing signs of nervousness about the consequences.
The first response was psychologically understandable. Falling prices have long been associated with a stagnant economy and hopes that inflation would return have become associated with expectations of improved prosperity. The problem is that the end to deflation seems to be arriving too soon. If it really has come to an end, and we are not being given a false signal by a temporary blip in consumer prices, then the underlying growth of the economy is depressingly slow.
The economy has only grown at 1.1% p.a. for the past decade or more. If deflation is now truly a thing of the past, this slow growth must have been adequate to absorb the economy’s spare capacity.
To take an optimistic view of Japan’s growth potential it is necessary to believe that the trend growth rate will now improve sharply, or that there is still spare capacity in the economy.
Sudden changes in the underlying growth rate of an economy are possible, but rare. Thus the most reasonable case for optimism is that prices have been given a temporary boost by the weak yen and rise in the oil price. Prices could start to weaken again provided that three conditions are fulfilled. The yen and the oil price will need to stabilise, expectations of inflation must remain subdued and there must still be unused capacity in the economy.
The need to consider expectations adds to the difficulties of making reliable forecasts. Even the most skilful economic forecasters, including those employed by central banks, are liable to error.
The problems posed by expectations are partly that they are volatile and can change quickly and partly that they have a direct impact on inflation itself. As expectations change, businesses respond by bringing forward or delaying changes in prices and being more or less willing to resist rises in wages. So economic theory puts great emphasis on the role of expectations and holds that central banks should respond vigorously if they change.
If interest rates are not raised sharply when expectations of inflation rise, they tend to increase even further. This seems to have occurred in the 1970s. Expectations continued to rise despite higher interest rates and rising unemployment. The result was a combination of stagnant output and rising inflation, which became known as stagflation. In order to break the vicious cycle, Paul Volker, who was then Chairman of the Federal Reserve, had to raise American interest rates to 14%. This would not have been necessary had interest rates previously been raised more aggressively. The overall result of the earlier caution was that the cost, in terms of output and jobs lost, was unnecessarily high. It would have been much less had the world’s central banks raised interest rates sharply when inflationary expectations first picked up.
If the trend growth rate of the economy has only been 1.1% p.a., the current rate will have to slow sharply to stop inflation accelerating. If the Bank of Japan responds weakly, then expectations of future inflation will rise and it will then require even higher rates of interest to bring the economy back into balance.
The first steps towards a tighter policy are expected in April. This will not, at first, involve any rise in interest rates, as this cannot take place until the deposits of commercial banks with the central bank have been cut back. This process will take at least three months and so interest rates are unlikely to be increased until autumn at the earliest.
There are fears that if the Bank of Japan acts too soon, the economy will slip back into recession. These concerns are felt strongly by several LDP politicians who are anxious that the economy should be robust in mid 2007, when the Upper House elections are due.
Small rises in interest rates may not be sufficient to slow the growth of the economy to a rate at which inflation will stabilise and the central bank will be under great pressure not to raise them sharply. The Bank of Japan will thus need to be very alert to changes in expectations about inflation. It seems likely that the risks of premature action are overstated and delay will be more dangerous.