Deflation and Waiting Consumers

August 23, 2010

The NYT had an article this morning warning of the dangers of Japanese-style deflation. While Japan has suffered from weak growth since the collapse of its stock and housing bubble, deflation has not been a serious factor in this weakness. Consumer prices in Japan fell in 6 of the 19 years from 1991 to 2008. The largest decline in this period was a 0.9 percent decline in 2002. (Japan’s CPI fell by 1.4 percent in 2009 and is projected to do the same this year.)

The consequences of relatively low rates of deflation are minor. While the article asserts that deflation causes consumers to delay purchases this is implausible on its face. A 1.0 percent rate of deflation would mean that if a person delayed buying a $500 television set for 6 months, they would save $2.50. The gains from delaying smaller purchases would be proportionately less.

The problem facing Japan (and now the United States) is that it would be desirable to have a lower real interest rate. Since nominal rates cannot fall below zero, an inflation rate that is negative makes matters worse by raising the real interest rate. However, the fact that prices are actually falling is not important. The drop in the rate of inflation from 0.5 percent to -0.5 is no different in its impact on the economy than the drop in the inflation rate by 1.5 percent to 0.5 percent. Both are hurtful because they raise the real interest rate by 1.0 percentage point.

The article also wrongly asserts at one point that Japan is prevented from doing more stimulus because its debt is twice the size of the Japanese economy. This is not a constraint at present. The Japanese central banks hold close to half of the debt, so it does not impose a substantial interest burden on the country. Furthermore, markets are willing to buy government debt at extremely low interest rates, so there is little fear about default or inflation.

It is also worth noting that the Japanese central bank could adopt a policy of targeting a higher inflation rate, such as 3-4 percent. This course of action has been advocated by Paul Krugman, Ben Bernanke, and Olivier Blanchard, the chief economist at the IMF. An article that is ostensibly examining the options available to Japan’s policymakers should have noted included this one.

 

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