Persistently low inflation—running below the Federal Reserve’s two percent target since 2008—has led some to suggest that the United States may have entered a period of long-run economic stagnation. Support for the most pessimistic forecasts along these lines often is based on the case of Japan, where the economy’s deflationary slump is about to enter its third decade. But while the Japanese case provides an example well worth studying, the Japanese data, when examined with the help of modern macroeconomic theory, also illustrate an important lesson for how the United States can avoid a similar deflationary outcome.
To illustrate the basic issue, Figure 1, below, plots the consumer price index for Japan since 1955. These data, usually converted to growth rates to measure inflation, are graphed here in levels so as to highlight the most striking fact: prices have not increased in Japan since the mid-1990s.
Conventional analysis holds that a central bank can combat falling inflation by lowering short-term interest rates. In fact, figure 2 shows that the Bank of Japan followed exactly this strategy, bringing the Treasury bill rate down to a fraction of one percent as inflation fell to zero in 1995. But when, as in Japan, interest rates remain low not just for years but for decades without putting any upward pressure on prices, something must be wrong—some key variable must be missing from the analysis.
Figure 3 fills in this gap by plotting the measure of monetary policy that has been ignored in virtually all other discussions of Japan’s performance: the growth rate of the broad, M2 money supply, which plummeted abruptly in Japan in the early 1990s and has not recovered since.
One can make sense of the inflation data by looking at both interest rates and the money supply. It may be true that during normal times, when long-run inflationary expectations remain anchored, lower interest rates can signal that monetary policy has become more accommodative, putting upward pressure on prices. It seems far more likely over the past two decades in Japan, however, that the direction of causality has been reversed. Instead, interest rates are low because expected inflation has fallen: bond-holders no longer need a higher interest rate to compensate for rising prices that, if present, would erode the purchasing power of their saving. Slow money growth therefore represents the driving force behind both low inflation and low interest rates.
To make this conclusion more compelling and more general, it can be helpful to construct another example that is the “mirror image” of the Japanese case today. Suppose, by sharp contrast, that inflation had averaged 10 percent per year in Japan since 1995—a rate that by any reasonable standard would be viewed as much too high. Suppose, as well, that Japanese Treasury bill rates fluctuated around 12 percent over the same two decades. And suppose, finally, that over this 20-year period, M2 grew at the same high rates—in excess of 15 or 20 percent per year—seen during the late 1960s and 1970s. Would anyone seriously argue that the high interest rates were symptomatic of an excessively tight monetary policy? More likely, they would focus on the rapid money growth as the common causal factor behind both high inflation and the high interest rates.
These two examples—the first based on Japan’s actual experience since 1995 and the second based on a counterfactual—remind us of one of the most important and robust lessons that modern macroeconomics has to teach us. Inflation and deflation are similar problems with a common cure. Both have their causes in inappropriately fast or slow money growth, and both can be ended by monetary policies that act decisively to bring money growth back to more reasonable levels. In an earlier discussion that complements our own, David Laidler quotes Canadian economist Doug Purvis in order to summarize this lesson: “sound money, and plenty of it!” By this, Purvis meant that the central bank should allow the money supply to grow fast enough to avoid deflation, but not so fast so as to cause excessive inflation. Indeed, as Laidler discusses, Japan’s own experiment with “quantitative easing,” which began in 2001, did appear to have positive effects on both spending and inflation, before it was abandoned in 2006.
Strangely, central bankers around the world appear to have forgotten this simple lesson. Despite seeing the clear example provided by Japan, policymakers at the Federal Reserve have paid less, not more, attention to measures of broad money growth since the mid-1990s. That’s a pity. By emphasizing in public statements that they are both willing and able to use monetary policy to control the growth rate of money, Federal Reserve officials could easily reassure Americans that the United States need not ever suffer from “Japanese-style” deflation.
Michael Belongia is a professor of economics at the University of Mississippi. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee. You can follow him on Twitter here.
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