Higher Expected Inflation Needn't Be Self-Fulfilling

June 29, 2009

Harvard Professor Marty Feldstein, mentor to a generation of economists including Ben Bernanke, has an Op-Ed article in today’s Financial Times entitled “The Fed must reassure markets on inflation” in which he postulates that very high projected Federal deficits over the coming ten years are boosting expected inflation and are a likely major factor behind the near-doubling of the 10-year Treasury yield from 2.26% last December to a high earlier this month of 1.98%.  As always, his logic is very compelling, especially the part about investors inferring that years of fiscal red ink dislodging confidence in sustained medium-term price stability.  Because of the similarities of U.S. experience this decade to what Japan went through in the last one, I like to run contemporary ideas about the U.S. economy past the Japanese prism.  As is often the case, this viewer raises doubts.

It is perfectly natural for expected inflation to respond to dramatic upward revisions in future deficit spending.  The same thing happened in Japan, whose public debt to GDP did in fact explode well above 100% of GDP.  Similar market concerns drove the 10-year JGB yield from a low of 0.67% in mid-September 1998 to 2.36% just 4-1/2 months later on February 5, 1999.  But here’s the rub.  Analysts got their metrics wrong.  Japan’s economy was headed for deflation, not inflation.  By May 17, 1999, the JGB yield had retreated all the way to 1.23%, and by June 2003, it got as low as 0.44%.  Another scare occurred in 2006 when the Bank of Japan considered deflation defeated and ended several years of quantitative monetary easing.  The 10-year yield peaked in May 2006 at 1.99% but had settled back to 1.61% four months later.  Fast forward another three more years, and the yield remains below 1.5%.

The missing link for Japan was a lack of inflation despite runaway deficit spending, a 67% increase in the monetary base during the three years to February 2004, and above-trend 2.8% per annum real economic growth over the four years between 1Q03 and 1Q07.  Consumer prices in Tokyo during the first half of 2009 fell 3.7% at a seasonally adjusted annualized rate (saar) and by 2.4% saar excluding seasonal food.  Total nationwide inflation and core inflation according to this uniquely Japanese definition dropped 1.1% in the year to May.

Japan’s experience suggests that an economy which has been through a financial market-inspired severe trauma becomes structurally less able to tolerate high interest rates and less predisposed to inflation.  Japan and perhaps the United States seem more analogous to what Keynes was discussing in his General Theory than the conditions of the 1950’s and 1960’s that seeded the great inflation of the 1970’s and 1980’s.  Like Einstein’s elusive and unsuccessful search for a a single law of Physics that would tie all the knowledge of that field into one coherent theory of the universe, it may be that no general theory of economic behavior will hold for all occasions.  The leap from un-tethered excessive Federal deficits to certain inflation makes sense under many circumstances.  But the deflations of the 1930’s and Japan’s more recent experience raise reasonable doubts when contemplating America’s future.  The path of future inflation and its expected trajectory need not line up well.

Copyright Larry Greenberg 2009.  All rights reserved.  No secondary distribution without express permission.

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