Global: Kindred Spirits
Stephen Roach (New York)
Most are quick to dismiss comparisons between America and Japan. Two different economic systems and two different policy regimes provide unmistakable sources of comfort for those who might otherwise fear that the US economy could slip into a Japanese-like deflation. The problem with this type of comparison is that it leads to a false sense of complacency. Just because America hasn’t followed the Japanese script to a tee, doesn’t mean it will avoid the same endgame. The same is true of Germany -- and the rest of a German-dependent Europe. The Japanese do not have a monopoly on deflation.
It is generally recognized that monetary policy holds the key to the deflation fight. That was certainly the verdict of a now famous study by 13 staff economists of the Federal Reserve Board published a year ago (see Alan Ahearne et al., “Preventing Deflation: Lessons From Japan's Experience in the 1990s,” Federal Reserve International Finance Discussion Paper 729, June 2002). In retrospect, the Fed study offered a blueprint of what was to come as the US central bank finally faced up to the risks of deflation. And it was a script that was largely derived from a very careful study of the Japanese experience. The key premise was the risk-reward calculus behind the critical judgment call of the monetary authority -- when to fight deflation. On this count, the recommendation was clear: As soon as the central bank views the risk of deflation as “significant,” it must then treat such an outcome as its central case. A failure to do so is the height of irresponsibility. If the central bank is wrong and fails to pre-empt deflation, all is lost. If, on the other hand, the monetary authority errs on the side of providing too much stimulus, an acceleration in inflation from modest levels can be remedied after the fact. The latter risks are well worth taking as the price to pay in avoiding the dire consequences of the deflationary endgame.
The trickiest part of this policy framework hinges on the word “significant” in judging the seriousness of deflationary risks. An educated guess would place the worry threshold somewhere in the 20% zone. Never mind that policy makers publicly use the word “remote” to depict their assessment of deflation risk. They have to do that -- it is critical to the public relations campaign that is aimed at quashing deflationary expectations. It’s the private risk assessment that matters most -- the odds that the authorities place on deflation in their closed-door discussions. The fact that America’s monetary authorities finally came clean on their risk assessment on 6 May -- admitting explicitly for the first time that the odds were skewed more toward deflation than inflation -- is reason enough to believe that the Fed’s private concerns have now breached the “significant” threshold. The anti-deflationary game-plan is now the operative consideration shaping US monetary policy -- and, in my view, is likely to be so for some time to come.
Because America is not Japan and because the Fed now seems to be quick to the trigger in fighting deflation, financial markets have concluded that the battle has already been won. That worries me. A careful assessment of the anti-deflationary responses of the Bank of Japan and the Federal Reserve reveals more similarities than differences in the reactions of the two central banks. Consider the following comparative chronologies:
The Japanese equity market peaked in December 1989. Over the next 15 months, the BOJ continued to push up nominal short-term interest rates before starting to ease in April 1991. Many believe this was the fatal blunder that then led to deflation -- a monetary tightening in a post-bubble climate. Yet the nearly 200 bp increase in the call money rate over this period was nearly matched by a 180 bp acceleration in Japanese inflation that also occurred during this same interval; the year-over-year CPI comparison in Japan went from 2.2% in June 1990 to 4.0% in November 1990. In other words, not fully realizing the severity of what was to come, the BOJ responded to persistent inflationary pressures and pushed up real short-term interest rates by about 20 bp in the early stages of Japan’s post-bubble era. That hardly qualifies as a wrenching monetary tightening.
The Fed’s initial response to the popping of America’s equity bubble doesn’t look all that different than that of the BOJ. The US central bank held the nominal federal funds rate steady at 6.5% for ten months after the equity market crested in March 2000. During that period, CPI-based inflation was basically steady at around 3.5%, implying little change in real short-term US interest rates in the early phase of America’s post-bubble era. In essence, the difference between the initial post-bubble responses of the two central banks is barely noteworthy: The BOJ tightened real short-term interest rates by 20 bp in the first 15 months of Japan’s post-bubble period, whereas the Fed held real rates steady in the first 10 months of America’s post-bubble period. That’s not much of a difference, in my view.
Of course, both central banks finally did see the light. The Fed began easing in January 2001, and over the next 30 months took the federal funds rate down by 550 bp to the 1% level, where it currently stands. Over that same period, CPI-based inflation has receded by about 160 bp from 3.7% in January 2001 to 2.1% in May 2003. That translates into a drop of about 390 bp in real terms. Interestingly enough, as seen in real terms, the results for Japan in the first 30 months of the BOJ’s post-bubble easing campaign are not all that different. The call money rate was taken down from 8.56% in March 1991 to 3.09% in September 1993, a drop of 547 bp. Japan’s CPI-based gauge of inflation decelerated by 209 bp over that same period -- going from 3.6% in March 1991 to 1.5%, 30 months later in September 1993. That translates into a 340 bp reduction in real short-term Japanese interest rates over that same period. In other words, Japan’s easing over that earlier period was not all that different than the Fed’s easing of 390 bp in real short-term rates over the past 30 months.
This comparative analysis raises an obvious and important question: What matters more in assessing the impact of monetary policy -- the level or the change in real interest rates? On the basis of the former, the Fed is clearly the aggressor when compared with the BOJ. It has succeeded in pushing the nominal federal funds rate below the inflation rate at a relatively early juncture in America’s post-bubble era; based on the headline CPI, America went into a “negative real interest rate” regime in late 2002. The BOJ, by contrast, has still not been successful in pushing real interest rates into negative territory. That reflects the “zero-boundary” constraint on nominal interest rates -- that the monetary authorities can only go so far in chasing an inflation rate that quickly morphs into deflation.
I have long maintained that changes are far important than levels in assessing the impacts of real short-term interest rates on the US economy. After all, the real interest rate level is a rather arbitrary statistical construct; focusing on the level of such a metric implies that there are “threshold effects” in stimulating or restraining activity in credit-sensitive sectors. Under normal operating conditions, the ups and downs of real interest rates are key in driving the ups and downs of the growth cycle in the real economy. If a central bank is running an unusually tight monetary policy for some reason, it does not have to drive real rates down to historic lows in order to get the economy moving again. It merely needs to provide enough stimulus to relieve inflation-adjusted financing constraints. That will usually be enough to spark a revival in those sectors typically most responsive to interest rates -- namely, consumer durables, homebuilding, and business capital spending.
And that, of course, takes us to the final twist in this tortuous road -- the limits of monetary policy in a deflationary climate. There comes a point in the battle when the central bank can run out of ammunition. The BOJ has hit that point -- it is now completely out of basis points as Japan’s aggregate price level is now falling. That leaves the BOJ with positive real interest rates and unable to lower them. The options on real rates have been closed off -- in terms of both changes and levels. The Fed, by contrast, still has some ammunition left -- namely, 100 bp in terms of the nominal federal funds rate. And the US is still running a positive inflation rate. Consequently, unlike Japan today, America still has scope for real interest rate relief. Currently, 30 months after it began its post-bubble easing, the Fed has only 100 bp of nominal interest rate ammunition; by contrast, in September 1993, 30 months after its post-bubble easing campaign began, the BOJ had about 250 bp of nominal interest rate relief left in its arsenal. The Fed currently has more firepower left than the BOJ did at a comparable juncture in its battle. And so I am left with the question: Why didn’t they use it?
Which takes me to the bottom line: America is not Japan. And the Federal Reserve is not the Bank of Japan. But the two central banks are kindred spirits -- they have much in common in the early stages of their respective post-bubble journeys. Financial markets need to be wary in giving the Fed the benefit of the doubt for learning the lessons of Japan. Nothing should be taken for granted in the battle against deflation.
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