Special Report 2010/14

Deflation, here we come?

Deflationary risks are rising in the advanced the burst of asset bubbles has weakened economies. This has made some worry that a to such an extent that Japan-style deflationary episode is awaiting us. (core) rates are falling below In our view, these particular concerns are central banks’ comfort zones. exaggerated. First, negative output gaps do not always commensurate with falling . Figure 1: Global risks are on the rise Index Index Second, the burst of Japan’s asset bubbles, IMF Deflation Vulnerability Indicator 0.6 0.6 which dwarfed the bubbles we saw in the High risk (e.g. Ireland, Japan and Spain) 0.5 0.5 current crisis, got underway when the country Moderate risk (e.g. Germany, France, Italy, Portugal, Greece and the US) started ageing. Third, the yen’s strong appre- 0.4 0.4 ciation further posed downward pressure on 0.3 0.3 domestic prices. Lastly, Japanese policymakers 0.2 0.2 were somewhat late in responding to the 0.1 0.1 country’s economic woes. That said, the risks Low risk (e.g. the UK, Sweden, Australia, China) of deflation will not go away until the private 0.0 0.0 94 96 98 00 02 04 06 08 10 sector deleveraging comes to an end. % of GDP % of GDP Private sector balance 14 14 Start of the Japan's deflationary era Why fear Japan? 12 financial crisis 12 Negative macro news has made it quite 10 10 8 8 fashionable for participants to draw 6 6 parallels between the current global macro- 4 4 2 2 economic woes and Japan’s “lost decades”. In 0 0 -2 -2 this report we will investigate whether the For Japan t=1991 -4 For others t=2008 -4 t is measured in years concerns are valid or not. This is particularly -6 -6 relevant for countries that are busy repairing their balance sheets. Falling into a vicious Japan US UK Eurozone debt-deflation spiral could force many % % 250 250 Domestic banking credit/GDP and financial crises: households and firms to throw in the towel, Advanced economies, 1997-2010 200 200 which would weaken banks’ balance sheets 150 150 further. The public sector will also face more 100 100 difficulties in achieving debt sustainability. 50 50

0 0 Reasons to be afraid -50 -50 The IMF deflation vulnerability indicator -100 -100 (DVI), which covers a range of indicators 1 for major economies, shows that the risks of Change in credit/GDP 1997-2007 Change in credit/GDP 2007-2010 deflation has reached a record high – with Source: IMF, EcoWin, Reinhart and Reinhart (2010) some countries being especially at risk (see figure 1, top panel). Quite understandably, What’s even more troubling is that the the private sector deleveraging process in deleveraging process has just got underway. the West (see figure 1, middle panel) after The recent study of Reinhart and Reinhart (“After the fall”, 2010) shows that domestic 1 Various indices; GDP growth and the output credit/GDP drops, on average, by 38% gap; credit growth; monetary aggregates; the real exchange rate and equity prices. points – an amount comparable to the surge

ERD / FMR www.rabobank.com/kennisbank R Special Report 2010/14: Deflation, here we come?

before the crisis (44%-points) – and lasts after PLOG episodes was equal or lower than around 7 years. As such, we may expect a inflation before the PLOG episode (see figure 2, significant contraction of credit/GDP in the bottom panel). In other words, has advanced economies going forward (see tended to taper off at very low positive figure 1, bottom panel). inflation rates.

This time is different? The reason why countries did not fall into There are several good arguments for deflation partly reflects downward nominal expecting the advanced economies to steer rigidities ( unions despise wage clear of a protracted period of falling prices. cuts). Well-anchored inflation expectations – thanks, in part, to central banks’ higher in- Large output gaps are not always flation fighting credibility – helped too. Lastly, deflationary: Conventional wisdom dictates with more ‘globalisation’, inflation has become that massive output gaps in the advanced less sensitive to domestic spare capacity. economies, which are larger than Japan’s in the 1990s (see figure 2, top panel), will lead to Asset bubbles were bigger in Japan: downward price pressures. Equities did not appear to be (significantly) But Meier (2010) 2 studied inflation dynamics overvalued ahead of the financial crisis in the during 25 Persistent Large Output Gap (PLOG) advanced economies. Price-earnings (P/E) episodes 3 in 14 advanced economies (1970- ratios of the US S&P 500, the UK FTSE 100 and 2004) and found that, in all cases, inflation the German DAX 30 in Jan 2008 were 17.9, 10.7 and 10.8, respectively. In Japan during Figure 2: Output gaps not always deflationary the late 1980s the P/E ratio was hovering % of potential GDP % of potential GDP Output gap 4 4 around 50 before the stock market collapsed. Start of the Japan's deflationary era financial crisis 2 2 Figure 3: Asset bubbles in Japan were huge 0 0 % % 700 (rebased) 700 -2 -2 Peak of the market Japan's deflationary era 600 600 -4 -4 For Japan t=1989 For other countries t=2007 For Japan t=1991 500 t is measured in years 500 For others t=2008 -6 t is measured in years -6 400 400

-8 -8 300 300 200 200 Japan US UK Eurozone 100 100 0 0 % 25 o e 45 line d o 25 Persistent Large Output Gap is 20 (PLOG) episodes in 14 Japan (Nikkei 225) US (S&P500) p advanced countries (1970- UK (FTSE100) Germany (DAX30) e 2004 ) G O L 15 P Index House Index (rebased) e Peak of h JP 74-76 300 300 t 10 SE 80-83 the market Japan's deflationary era f o r DK 80-83 IT 82-86 a US 74-76 250 250 e 5 IT 92-94 CA 81-84 GB 80-83 y l SE 92-94 NL 81-85 a DE 82-85 in 0 CA 95-97 % 200 200 f JP 01-03 CA 91-94 n o ti Deflation a -5 150 150 fl In -5 0 5 10 15 20 25 Inflation one year before the PLOG episode 100 100

Source: Rabobank, Reuters EcoWin, Meier (2010) 50 50

Japan (Tokyo) US (CS 10 cities) UK Spain Ireland 2 Still minding the gap. IMF Working Paper 189 . 3 Defined as 8 quarters of negative output gaps Source: Rabobank, Reuters EcoWin exceeding 1.5%.

October 2010 Rabobank ERD / FMR 2 Special Report 2010/14: Deflation, here we come?

Equally, the bubble in the Japanese property biggest asset price corrections in the current market dwarfed that of the US, the UK, Ireland crisis (e.g. UK and the US) have significant and Spain. The anecdote that the Imperial positive population growth and don’t face an Palace in Tokyo was valued higher at one point ageing population to the same extent. in time than all the real estate in the state of California is well-known. The burst of asset Significant yen appreciation was a major bubbles in Japan, therefore, brought about a headache: Following the burst of asset far larger and protracted negative wealth effect bubbles, the yen appreciated significantly on a for the private sector (see figure 3). trade-weighted basis, mainly because of the country’s current account surplus. This acted Rise in consumer prices was not as an extra downward drag on Japanese justifiable: Not only did asset prices rise domestic prices. The current experience of spectacularly, consumer prices in Japan were advanced economies is very different (see also very high (see figure 4). Part of the rise in figure 5). prices can be explained by a surge in credit prior to the crisis. Between 1982 and 1996, Figure 5: Yen appreciated significantly Index Effective exchange rates Index (rebased) credit/GDP rose 67%-points and then started 190 190 Start of the Japan's deflationary era contracting sharply. This event goes a long financial crisis way in explaining the impressive rise in the 160 160 in Japan. In that period, 130 130 emerging markets were not flooding the world with cheap . So the rise in inflation could 100 For Japan t=1991 100 For others t=2008 go unchecked for many years. t is measured in years 70 70 Figure 4: Consumer prices were out of line Index Index Japan US UK Eurozone 140 Comparative price levels 140 (CPI, 2005 benchmarks) Source: Rabobank, Reuters EcoWin 120 120

100 100 Japan’s slow and muted policy response 80 80 was a mistake: When crisis made landfall in 60 60 Japan, fiscal policymakers were rather slow in 40 40 providing stimulus for the economy. In the 20 20 current crisis, leaders of the Western world 0 0 quickly realised that the hesitance of Japan in 60 65 70 75 80 85 90 95 00 05 10 the 1990s and the US during the 1930s was a US EMU-11 JP mistake. So they not only allowed automatic Source: Rabobank, Reuters EcoWin, IDB, EC stabilisers to operate in full, they took a

number of policy measures to stimulate their Japan entered the crisis with a poor economies (see figure 6, top panel). The flip demographic structure: Japan’s working age side of this bold in the advanced population peaked in 1995, at 87.3m, and has countries was quicker deleveraging of the now fallen to roughly 81.5m. Simultaneously, private sector. Put differently, households and the older population (65+) has risen from firms in the West did not postpone repairing 18.3m to 29m. The ageing of Japan's their balance sheets like their Japanese population brought about an increase in the counterparts. dependency ratio, which in turn contributed to Another notable step taken by advanced deflation amid weak aggregate demand countries was addressing the problems of the growth. The countries that faced some of the

October 2010 Rabobank ERD / FMR 3 Special Report 2010/14: Deflation, here we come?

banking sector early on. Over the period 08Q1- bankers also quickly realised that 10Q2 around 50% of capital raised by banks in unconventional support measures (i.e. the UK and the eurozone was through direct quantitative easing) are necessary. In a matter government support. Japanese authorities, on of months, the balance sheets of the Fed, the the other hand, allowed zombie banks to roam Bank of England (BoE) and the ECB expanded for far too long. rapidly while it took the BoJ a decade to come up with similar measures (see figure 6, bottom Figure 6: Policymakers responded quickly panel). % of GDP % of GDP Public sector balance 4 4 Start of the Japan's deflationary era 2 financial crisis 2 Conclusion 0 0 Deflation risks in the advanced economies have -2 -2 -4 -4 risen against a weak economic backdrop and -6 -6 still large output gaps. This does not -8 -8 necessarily mean we are going to fall into a -10 For Japan t=1991 -10 For others t=2008 t is measured in protracted period of falling and prices -12 years -12 -14 -14 like Japan. The asset bubbles we saw in the current crisis were large, but were nowhere Japan US UK Eurozone near as big as the ones Japanese authorities

% % Policy rates had to deal with. Bashing Japanese 7 7 Start of the Japan's deflationary era financial crisis policymakers has become a popular pastime of 6 6 5 5 sorts, but next to the advantage of hindsight, 4 4 Western policymakers were simply dealt a 3 3 better hand to begin with. What’s more, most For Japan t=1991 2 For others t=2008 2 t is measured in advanced economies are not ageing as fast as years 1 1 Japan did since 1995. Finally, none of the 0 0 major appreciated as strongly as the yen did during the 1990s. Bank of Japan Federal Reserve Bank of England ECB

Index, Index, We aren’t out of the woods yet. Sovereign debt crisis start=100 liabilities (% of GDP) crisis start=100 260 260 concerns have forced most governments to Start of the financial crisis Japan's deflationary era 240 240 220 220 head for the exit even though the private 200 200 sector still has trouble standing on its own feet. 180 180 Central bankers are fast running out of 160 For Japan t=1991 160 For others t=2008 140 t is measured in quarters 140 meaningful ammunition. A deflationary threat 120 120 lingers until the private sector deleveraging 100 100 80 80 comes to an end. Yet Japan’s experience isn’t the compass to go by and overstates the

Weighted average of ECB, BoE & Fed Bank of Japan deflation risks we face. Source: Rabobank, Reuters EcoWin, Meier (2010) October 2010 Monetary policymakers also stepped in to Shahin Kamalodin (+31 30 2131106) compliment loose fiscal policies. In a highly [email protected] coordinated manner, central banks managed to Jan Lambregts (+44 20 76649669) slash policy rates far earlier than the Bank of [email protected] Japan (BoJ) managed in the early 1990s (see figure 6, middle panel). Since the policy rates www.rabobank.com/kennisbank were constrained by the zero-bound, central

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