Emerging from Deflation

UEMURA Shuichi
Senior Fellow, RIETI

At long last, the word "inflation" has begun to appear in books displayed at the checkout counter of bookstores. Although books with "deflation" in the title are still in the majority, things are beginning to take on a different look, given the fact that just a year ago pundits were declaring the 21st century "the age of deflation," and arguing over whether Japan would ever be able to escape from its deflationary spiral. Of course, people are fickle. But taking these developments into account, can we say that we are finally approaching the end of deflation?

Deflation and deflationary expectations

The first question to ask is whether Japan is still in deflation? When we look at the GDP deflator, which is a price index used in GDP statistics, the latest figure for the April-June quarter fell 2.7 percent on a year-on-year basis. I will not go into details but most economists believe the GDP deflator, compared to other price indexes, has a downward bias because of the way it is calculated. For comparison, Japan's consumer price index (CPI), excluding perishable food, edged down by 0. 2 percent in July from a year earlier, while the corporate goods price index (CGPI) posted a year-on-year increase of 1.6%. Thus, although the picture differs depending on which statistics we look at, it is difficult to conclude that Japan has come out of deflation. What is important in considering the future direction of the Japanese economy, however, is that people's expectations regarding future prices are beginning to change.

In economics, it is generally assumed that most decision-making by economic entities does not depend solely on events in the present; they are also affected by predictions and expectations of future events. For instance, in making investment decisions, people normally look at real interest rates, which take inflation into account. The inflation rate referred to here is not the current inflation rate but the "expected inflation rate," i.e., the rate at which prices are expected to increase in the future. Because Japan has been in deflation for so long, many economists have, until recently, believed the expected rate of inflation was negative. But might not inflationary expectations have turned positive?

Behind the changing deflationary expectations lies economic recovery

Needless to say, it is next to impossible to directly monitor expectations just as they are. In the field of empirical analysis, expected inflation rates are therefore estimated in various ways. Researchers often turn to the Bank of Japan's Tankan quarterly survey of business sentiment to assess corporate expectations on prices. More specifically, they use the price-related survey items that relate to whether companies expect output and input prices (i.e., product prices and raw material prices in the case of manufacturers) to go up or down.

With respect to household expectations, for which very few statistics have been compiled, some hints can be found in the "Survey on the General Public's Mindset and Behavior," another quarterly survey by the BOJ. In the latest series of surveys conducted in June (for which valid responses totaled 2,890), the BOJ asked individuals aged 20 and above nationwide how they sense changes in prices. Respondents were asked to estimate by what percentage prices had changed from a year ago, and their expectations for price changes one year from now and over the next five years.

As to the perception of current price levels (as compared to a year ago), the share of respondents who feel that "prices have gone up" is roughly equal to that of those who feel that "prices have gone down," at 22.0%. The average change in the perception of price levels comes to an increase of 0.2%. In contrast, asked about their outlook for price levels one year from now, 40.0% of respondents believe that "prices will go up," whereas only 6.3% believe that "prices will go down." On average, respondents expect the overall level of prices a year from now will be 1.6% higher than at present. Furthermore, more than 60% of respondents believe that "prices will go up" five years from now, with the average price change estimated by all respondents coming to 1.9% per annum.

The mechanism of how price expectations are formed is not understood. But it is quite plausible that the recent sharp rise in crude oil prices, which is passed on to consumers in the form of higher gasoline prices and so forth, is affecting sentiment. Another important reason behind the changing perception of prices is that people are beginning to sense an economic recovery. This is clear from respondents' answers to questions concerning economic conditions in the same survey, which points to a substantial improvement in sentiment from a year earlier. The improving trend in consumer confidence has also been observed in other surveys such as the consumer confidence index of the government's consumer confidence survey.

The BOJ maintains cautious stance

Against the backdrop of receding deflationary expectations, the BOJ's monetary policy has naturally come under renewed scrutiny. The BOJ is seeking to enhance its dialogue with the market and to stabilize economic entities' expectations basically by doing two things: 1) clarify the bank's outlook on economic activities and prices semiannually, i.e., in spring and autumn, and then review the outlook every month and publish the results in the "Monthly Report of Recent Economic and Financial Developments"; and 2) set an operational framework for monetary policy beforehand.

As to the outlook mentioned above, the BOJ's report released in April this year says, "It is...expected that slight downward pressures on prices will persist during fiscal 2004." The latest "Monthly Report of Recent Economic and Financial Developments" published in September also states, "Consumer prices are projected to basically continue falling slightly on a year-on-year basis." Thus, the BOJ has yet to change its cautious stance.

Meanwhile, with regard to the policy framework, the BOJ has continued its so-called quantitative easing policy that began in March 2001. Under the policy, adopted when nominal rates had already fallen to zero and could not decline any further, the outstanding balance of current accounts held by financial institutions at the BOJ is used as the operating target for its money market operations. Furthermore, the BOJ has pledged to maintain this quantitative easing framework - a de-facto zero interest rate policy - until year-on-year changes in consumer prices stabilize above zero. What should be noted here is that the length of time the BOJ is committed to maintaining the policy is based on changes in the price level that occur in the previous 12 months rather than expected changes in the future. In addition, the BOJ has doubly bound itself by setting another condition: that such an increase in prices must be an established trend before lifting the policy.

When a policy is implemented, it normally takes a while before it begins to have an effect. Therefore, policymakers are supposed to take steps preemptively. In this regard, the BOJ's quantitative easing policy, which is completely backward looking, is extremely unusual.

The financial market is stable for now

Under this framework, the fact that the BOJ maintains a cautious outlook on prices is sending out a signal to the market that it will be a long time before the central bank changes its policy. Three-month Euroyen futures remain at around 0.1%. This kind of stabilization effect - i.e., the effect of a certain policy framework currently in place to stabilize people's expectations and market rates - is called a "policy duration effect."

People calling for the introduction of an inflation targeting policy believe the BOJ, by setting a clear target for inflation, can directly affect people's expectations (with rises in expected inflation rates resulting in a decline in real interest rates), thereby pulling Japan out of deflation. Ironically, however, the BOJ's cautious stance on future prices is giving a sense of reassurance to people who want to see its ultra-easy monetary policy continue, including those who call for the introduction of inflation targeting.

Leaving deflation behind

Real GDP in the April-June quarter (second preliminary estimate) grew at an annualized rate of 1.3 percent from the previous quarter, which was less than market expectations. Because quarterly growth figures tend to fluctuate widely, it is premature to conclude that the Japanese economy has entered a slowdown based solely on the latest quarterly growth rate. And many economists remain uncertain of the future performance of the Japanese economy, wondering just how long the momentum of recovery can be sustained at a level strong enough to pull Japan out of deflation. But once they begin to feel confident about the economy, what will happen on the market? It is impossible to predict how the financial market will react after years of ultra-low interest rates and easy monetary policy.

Against this backdrop, the Nihon Keizai Shimbun reported on September 14 that the Ministry of Finance has begun to consider increasing issuance of inflation-resistant government bonds, such as floating-rate bonds and inflation-indexed bonds, in a bid to ensure smooth marketing of government bonds. Of all the expected moves by government to prepare for an exit from deflation, however, how the BOJ will respond to this challenge is drawing the keenest attention.

September 21, 2004

September 21, 2004

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