CPI Inflation in the Group of Seven and Implications For the Fed's Exit Strategy

November 3, 2009

According to price data released by the OECD today, on-year inflation in the Group of Seven (U.S., Euroland, Japan, Britain and Canada) printed at negative 1.0% but ranged widely between minus 2.2% in Japan and plus 1.1% in Britain.  The United States registered the biggest percentage point decline between the year to September 2008 and the year to September 2009.  U.S. inflation fell 6.2 percentage points (ppts) from 4.9% to minus 1.3%.  The comparable declines in other elements of the G-7 ranged tightly from 3.9 ppts in Euroland to 4.1 ppts in Britain and 4.3 ppts in both Japan and Canada .

Core inflation in the year to September 2009 was very similar in Canada (1.7%), Britain (also 1.7%), the United States (1.5%) and Euroland (also 1.5%).  Core inflation excludes food and energy, which tend to move erratically and much less consistently than other prices with supply and demand imbalances, is called core-core inflation in Japan.  Japan is a conspicuous deflationary outlier, with a core CPI inflation rate of minus 0.9%.

A consequence of Japan’s inescapable deflation has been the Bank of Japan’s inability to raise interest rates despite publicly stated intentions to do so before money markets suffer lasting structural damages.   Japanese interest rates were not always abnormally low.  The overnight uncollateralized call money rate averaged 6.46% in 1991-2, almost three times greater than the average 2.3% rate of inflation in those two years.  But since the Bank of Japan overnight target rate fell to 0.5% in September 1995, over 14 years ago, it has never climbed above that tiny level.  Japan has been caught in a proverbial liquidity trap.  Having lived on the intravenous feeding of zero or near-zero interest rates plus two episodes of quantitative easing, the Japanese economy no longer retains the internal resilience to go off the support without experiencing a serious relapse.

Regular readers of this blog know that I’ve often invoked the experience of Japan for insights into the difficulties that the Fed, Bank of England or even ECB might encounter in trying to implement a prudent exit strategy, such as the Reserve Bank of Australia is now doing.  Contrasting core inflation rates suggest a distinctness to Japan’s circumstances that truly set that economy apart from other advanced ones.  Being in untested waters, I accept the premise that what happened in and to Japan stays in Japan with no implications for other countries, but I do this only up to a point.  One will not be sure if the consequences of Japan’s zero interest rate policy are specific ones or more universal for any central bank wandering down a similar policy path. 

The U.S. recovery was unquestionably heavily reliant on extremely loose fiscal and monetary policies and the fact that the Federal government did not nationalize major money center banks as was feared last winter.  These elements produced a revival in confidence that consistently outpaced the reality embodied in medium-term growth prospects.  Root causes of the Great Recession remain in place:

  • Unsustainable current account imbalances;
  • An overly deregulated, distrusted, and unstable global financial system;
  • The consequences of rapid globalization and technology-inspired cultural change and the backlash against free trade;
  • An international monetary system designed for the mid-20th century that has become excessively dependent on the dollar;
  • A currency policy in China, now the world’s third biggest economy, that uses capital constraints and intervention to keep the yuan undervalued;
  • And shared fear that Armageddon from global warming, microbes, endless war, smothering debt, or proliferating weapons of mass destruction is a question of when, not if.

My worry about the tolerance of economies for a process of monetary policy normalization continues.  If structural problems are not rectified, policy support enables economies to tread water but not to evolve to a less fragile state where growth can be sustained after the support is removed.  Too much of the economic upswing since spring, like the plunge beforehand, has been created by instant feedback loops from the financial system.  As the Fed meets this week, investors know that a rate increase remains far way but are spooked by the possibility that the Fed will flesh out the logistics of such a process well in advance.  Markets have lost the ability to price and allocate risk without careening from one asset bubble to another, and the existence of such bubbles predisposes markets to dramatic reversals when policies change.  NYU Professor Nouriel Roubini wrote a column in Monday’s Financial Times that cheap dollar-funded investments into a whole range of assets since early this year are producing extraordinary returns when combined with the capital gain on the depreciation of the liability currency, namely the dollar.  Those assets, Roubini postulates, have become way over-priced as a result, while the dollar cannot fall forever, and he proclaims the ensuing ugly dynamic in his title: “The mother of all carry trades faces an inevitable bust.”

The obvious trigger for this chain reaction will be the onset of Fed tightening.  Some would say Japan’s differences are far greater than any similarities with the U.S. economy.  I’m betting that a similar market and economic collapse accompanies the attempt to tighten U.S. monetary policy and stymies the process in an analogous way to what has happened repeatedly to the Bank of Japan.  In the name of policy transparency, Chairman Bernanke and the other Fed policymakers might consider making the case publicly why stock markets and the real U.S. economy will be able tolerate the reversal of U.S. monetary policy in a way that Japan’s have not. 

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



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