Deflationary Expectation Caused by Future Concerns

Faculty Fellow, RIETI

The Bank of Japan (BOJ) held its regular Monetary Policy Meeting on September 20 and 21, 2016 to define a new easing policy framework for guiding the short- and long-term interest rate, stressing its continuous resolve to achieve a price stability target of 2%. In the meeting, the BOJ also adopted an inflation-overshooting commitment (commitment to continuing with monetary easing for a while even after the price stability target of 2% is achieved) to wipe away any expectation of returning to deflation.

As explained by Shinichi Uchida, the director-general of the BOJ's Monetary Affairs Department, in the September 29th edition of the Nikkei Shimbun, the BOJ's stance is based on adaptive expectations, which is a hypothesis that people's expectations for the future is based on past experiences. Based on this hypothesis, the BOJ is making a plain, clear, and sound move to wipe away people's deflationary expectation, formed by past deflation experiences, by making a strong commitment to the price stability target of 2%.

However, things may not be that simple if people's expectations are affected by not only past experiences but also anxiety for the future.

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The theory of secular stagnation seen in Western economies also may be related to expectation changes. A 2015 research paper by New York University Professor Laura Veldkamp et al. showed quantitatively that the single financial crisis in 2008-2009 might have caused secular stagnation in the U.S. economy using the expectation formation mechanism.

According to the rational expectations hypothesis used in textbook economics, people form expectations about the future using all available information rationally. It assumes that, without structural economic changes, people's economic expectations do not change. In other words, a transient experience such as a financial crisis should not change expectations.

In contrast, the adaptive expectations hypothesis used in slightly older economics assumes that people expect what had happened in the past to recur in the future. If this theory is correct, the experience of a financial crisis should significantly alter people's expectations. However, it amounts to assuming that people do not have the ability to rationally predict the future, which is a little extreme.

In the real world, people are likely to form their expectations somewhere between rational expectations and adaptive expectations. The BOJ's analysis and policy decisions are also based on the assumption that people's formation of expectations are somewhere in-between the two. The paper by Veldkamp et al. has developed a new theory of the in-between mechanism of expectation formation.

Unlike the rational expectations hypothesis, Veldkamp et al. hypothesized that people do not know the shape of risk probability distribution in advance. Based on this premise, they estimated the shape of probability distribution using data gained from past experiences. In short, the hypothesis assumes that people gradually learn from experience to estimate the probability of a financial crisis. This can be called an expectation-learning hypothesis.

In the real world, people have no way of knowing the probability of a financial crisis in advance, and must learn it from experiences. The expectation-learning hypothesis also does not contradict with the concept of rational expectations in that people use currently available information to the best of their ability to predict the future. In fact, its concept extends the rational expectation hypothesis realistically.

According to the theory of Veldkamp et al., when a major financial crisis occurs, people use that information to estimate the shape of probability distribution, thereby altering estimation results significantly. People's expectation that "there will be no financial crisis" changed to the notion that a "financial crisis occurs once in several decades" after 2008-2009. A single financial crisis caused a permanent change of expectations.

According to Veldkamp et al., this change of expectations dampened down consumption and investment activities in the United States, and triggered long-term reduction in the gross domestic product (GDP) level.

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The concept that expectations are formed with learning from past experiences combined with rational future prediction makes it easy to explain arguments surrounding Japan's deflationary expectations.

If the deflationary expectations are attributable to past experiences (almost 20 years of deflation), the BOJ's powerful commitment to inflation should eventually generate inflationary expectations. Then, demand would become greater than the state of full employment, temporarily overheating the economy. The BOJ seems to be trying to trigger inflation by even accepting such a development.

However, this scenario would not eventuate if Japan's deflation were attributable to the increase in tail risk, as anticipated by Veldkamp et al. The biggest risk anticipated in the Japanese economy and which is attributed to domestic factors is fiscal crisis.

According to Veldkamp et al., the experience of the financial crisis drove up expectations of similar future crises in the U.S. economy. However, since Japan has not experienced a fiscal crisis, people's expectations for it are not boosted by past experiences. The problem is that, looking at the ever-increasing amount of government debt, Japanese people are anticipating an increasingly large impact from a future crisis.

As is widely known, Japan's government debt is accumulating exponentially, currently standing at 250% of the GDP (International Monetary Fund estimation). Government debt must be repaid with tax revenues received from taxpayers. In other words, it is the debt of all Japanese citizens.

Japan's government debt per capita amounts to just under 10 million yen. This means a family of four is laden with debt to the tune of 40 million yen insidiously. Japanese people find themselves in a situation whereby they don't know when and how they would be asked to repay the debt.

There will be an inevitable choice among a tax hike, government spending cuts or high inflation, and no one knows when which of these will eventuate and in what form. With the amount of debt increasing year after year, the amount of pain such development would cause to Japanese households is also increasing. In the given situation, Japanese people are too scared to spend, despite feverish encouragement from the BOJ to increase consumption.

The tail risk of a fiscal crisis in Japan has been rising each year with the increase of government debt. According to the theoretical model of Veldkamp et al., a continuous rise in tail risk would increasingly contract aggregate demand, which, in turn, not only would lower the GDP level but also reduce subsequent rates of growth. The trend of increasing downward pressure on demand would be perceived as chronic deflationary expectations.

In other words, we can draw a logical assumption that the exponential increase of Japan's government debt and the resulting increase of tail risk for fiscal collapse are intensifying the pressure of a demand contraction year after year, thereby causing long-term decline in the economic growth rate and creating sustained deflationary expectations.

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As both the government and the BOJ acknowledge, Japan's potential growth rate has dwindled in recent years to dip below 1%. The decline of potential growth rate is normally attributed to problems with technological advancement. In such case, in order to increase the rate of economic growth, a government should implement structural reforms (e.g., deregulation based on growth strategy) to increase the pace of technological advancement.

Yet, if the increase of fiscal tail risk is the cause of slow growth and deflationary expectations, it is necessary to show a clear roadmap for fiscal reconstruction to the people of this country. The BOJ's expression of commitment to overcome deflation alone is less than effective. In order to bring the nation out of deflation and regain economic growth, the government and the BOJ are required to unite in wiping away the tail risk of fiscal collapse.

>> Original text in Japanese

* Translated by RIETI.

October 17, 2016 Nihon Keizai Shimbun

December 22, 2016

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