What does a deflationary trap look like? Ask Japan!

Japan has endured 15 years of deflation with an average annual rate of price decline of minus 0.3% over that time. Bank of Japan Governor, Haruhiko Kuroda, recently articulated this deflation trap in a speech entitled “How to Overcome Deflation”:

“As actual prices declined due to those factors, deflationary expectations that prices will not rise but instead decline were generated among people. Subsequently, even if those factors that induced price declines diminished, once deflationary expectations became entrenched, people would make decisions and take actions on the assumption that prices would not rise. Through this process, deflationary expectations themselves created in a self-fulfilling manner an economy in which prices did not easily rise.”

The result is that higher real interest rates (nominal interest rates minus inflation) restrains business fixed investment and household spending, investors prefer to hold cash and safe haven government bonds over equities and other risk assets with people also less willing to take the risk of setting up new businesses. As Kurodo notes in his speech “Japan’s economy lost vitality and the growth rate declined, gradually undermined by by this moderate price decline”.

Why could Japan not overcome deflation? According to Kuroda “they fell short of showing a strong and clear commitment to achieve the price stability target by any means”. Draghi has made clear that the situation in Europe is different from the Japanese experience. However, if inflation continues to fall or even remains persistently low the ECB’s current strategy of just talking about the tools available to them will not be enough.