Last chapter in Japan’s deflation saga?

Japan has been mired in deflation since the Bubble Economy collapsed in the early 1990s. Deflation returned with a vengeance after the Lehman shokku, as the Japanese refer to the events of September 2008. Since that date, the Bank of Japan has done little to repel this monetary bogeyman. Last month’s great earthquake, however, forced the central bank to greatly expand its balance sheet. Other developments suggest that Japan’s long-running deflation saga may be entering a final chapter.

After nearly two decades of flat or falling prices, the Japanese accept deflation as a way of life. Their economy has been ensnared in history’s most enduring liquidity trap. Although banks are awash with cash, there has been little demand for credit. Incomes haven’t been growing and people expect prices to continue falling. The longer consumers defer gratification of their wants, the weaker the economy has become, and the more reason they have had to postpone purchases. This vicious cycle returned after Lehman’s collapse. The consumer price index fell by 2.5 per cent in the year to September 2009 and continued falling through to February. The bond markets expect Japan’s deflation to continue for many years.

The recent revival of deflation reflects the inherent fragility of Japan’s economy. The Bank of Japan must also share the blame. While the Federal Reserve and Bank of England responded aggressively to a feared, but non-existent, deflation, Japan’s central bank has been relatively inactive. Late last year, the Bank of Japan announced a Y5,000bn (roughly $60bn) asset purchase programme. By comparison, this measure was one-sixth the size of Ben Bernanke’s second round of quantitative easing.

Real interest rates in Japan have been higher than in the other leading economies. The relative tightness of Japan’s monetary policy has contributed to the yen’s near 35 per cent appreciation against the dollar since the onset of the credit crunch. The strong currency has exacerbated deflationary pressures. Despite this grim reality, the Bank of Japan has adamantly refused to change tack. Instead, prior to last month the central bank was urging the government to raise taxes.

The great destruction wrought by the Tohoku earthquake could well reinforce deflation pressures in the short run. Yet over a longer timeframe the situation looks more promising.

For a start, the G7 countries have intervened to prevent any further strong appreciation of the yen. Last month, the Bank of Japan increased bank reserves by Y25,000bn, an amount equal to 5 per cent of GDP. The central bank also doubled its asset purchase programme to Y10,000bn. There is an outside chance the Bank of Japan could go further and monetise some of the costs of reconstruction. The successful reflation of Japan’s economy in the early 1930s, when the Bank of Japan acquired bonds used to finance public works, has been commented upon.

The great earthquake constitutes a supply shock to Japan’s economy. Refineries, pulp and paper operations, chemical plants and auto factories were initially shuttered. Around a 10th of the nation’s electricity generation capacity has been knocked out. Rationing of electricity is likely to continue for some time. As a result, Japan’s output gap is set to narrow. This change could prove more than temporary if companies in sectors faced with chronic over-supply, such as the pulp and paper industry, decide against rebuilding ruined plants.

Japan’s deflation started when companies began paying down excessive debt burdens two decades ago. Given that Japan’s ratio of private sector debt to GDP is around half US levels and that Japan Inc now sits on piles of cash, this deleveraging must end sooner or later. Severe earthquake damage could kick-start loan demand, according to Nomura’s Richard Koo. “The private sector,” writes Mr Koo, “may be about to overcome the aversion to debt that has prevented a clean emergence from Japan’s balance-sheet recession.”

Other recent developments unrelated to the natural calamity have a bearing on the deflation question. Japan’s numerous pensioners have long been passive supporters of a falling price level. This rentier class has great political clout, owing to its over-representation in the Diet. On March 23, the Supreme Court called for a reform of the electoral districts. Robert Feldman of Morgan Stanley argues that “such reforms would end the systemic tilts in the electoral system towards deflation, agricultural protection, tax hikes and higher entitlements for the elderly”. Finally, external sources of inflation are lapping at Japan’s shores. Chinese import prices are rising. Resource-poor Japan is also exposed to soaring energy and raw materials costs.

There is always a chance that the Bank of Japan will return to its curmudgeonly ways and remove excess liquidity. Nevertheless, political, monetary, and supply-side developments over the past month all point to a shift in the nation’s deflation dynamics. If that shift turns out to be decisive, some good could emerge from Japan’s national tragedy.

Edward Chancellor is a member of the asset allocation team at investment manager GMO