Mario Draghi may have offered reassurance last week that the eurozone is not facing a Japan-style deflationary lost decade but, frankly, his reassurance is not terribly convincing. Japan’s problems were partly a reflection of a collective failure to foresee the deflation heading its way. As economists at the US Federal Reserve noted back in 2002: “Japan’s deflationary slump was very much unanticipated by Japanese policy makers and observers alike … this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation.”
Over the past 12 months, inflation throughout much of the world has dropped like a stone, ending up at levels wholly unanticipated at the end of 2012. If Japan’s problems partly stemmed from a failure to spot the onset of deflation, might it be that policy makers in the west could be sleepwalking into the very same problem? After all, inflation in both the US and the eurozone is now well below target, a result that should at least give central bankers pause for thought.
The arrival of excessively low inflation – or, indeed, deflation – is not always a problem. A positive productivity shock might drag prices down relative to wages, pushing real incomes higher. The same applies in the event of a major drop in energy prices (it is certainly the case that US inflation has been dragged lower thanks to the shale energy revolution).
And, as many observers currently believe, low inflation may simply be a lagging indicator of earlier economic weakness. On that basis, recent signs of renewed economic strength suggest inflation will head back up again over the next couple of years.
Low inflation is not always a lagging indicator, however. At the zero rate bound, further declines in inflation will raise real interest rates, make debt less digestible and, for the financial system, threaten an increase in non-performing loans. A financial system that is already fragile – as the eurozone’s is today – will then end up in an even worse position. Initial signs of economic recovery may then prove to be no more than a false dawn.
Rather than faster growth leading to higher inflation, lower inflation eventually leads to slower growth. In between, the credit system is slowly asphyxiated.
This was exactly Japan’s experience in the mid-1990s. Tentative signs of economic recovery in 1995 and 1996 created the impression that Japan was about to enjoy a sustained recovery that, in turn, would lead to higher inflation. It did not. Instead, an unexpected descent into deflation – despite the pick-up in activity – led to a sclerotic financial system, pathetically weak credit growth and, eventually, what became known as the first of Japan’s two lost decades. The normal cyclical causality went into reverse.
The large drop in inflation last year elsewhere in the world may only be a lagged response to earlier economic weakness but, if that is so obvious now, why was it that no one managed to forecast the drop a year ago? Might it be that, for the world as a whole, there is still a significant deflationary bias, even if deleveraging has shifted from the US and the UK through to southern Europe and, more recently, to more vulnerable parts of the emerging world? And, at the zero rate bound, does one country’s attempt through quantitative easing to reduce deflationary risks only lead to a weaker exchange rate which ultimately only serves to export its deflationary difficulties to other parts of the world?
None of these risks is reflected in current inflation forecasts. With central banks unwilling to admit they might miss their inflation targets (they are not in the business of forecasting policy error) and with the forecasting community more generally happy in the complacent belief that inflation will somehow automatically head back up towards target over the coming months, no one is forecasting a Japan-style outcome. That, however, is precisely the view the Japanese themselves reached in the mid-1990s.
For all the more encouraging recent economic news, persistently low inflation could be a game-changer. No one expects it to be but, as the Japanese discovered, that is ultimately why persistently low inflation could be such a big problem.
The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research