A Deflation Guru's Prescription for Japan


By Michael Wallace Last November, newly appointed Federal Reserve Governor Ben Bernanke made a pivotal speech before the National Economists Club in Washington, D.C. The topic? "Deflation: Making Sure 'It' Doesn't Happen Here." At the time, it was seen more as a case study of Japan's deflationary quagmire. But Bernanke's talk could equally be seen as a prescription against the U.S. falling into the same policy trap.

Fast forward to May. After sharp drops in the U.S. consumer and producer price indexes in April, "It" took center stage on Wall Street. In its May 6 policy statement, the Federal Open Market Committee referred to a "minor" threat posed to the U.S. by an overall decline in prices, and adopted a precautionary antideflationary policy bias. Smelling the possibility of easier monetary policy, financial markets took the Fed's bait, with an impressive rally in both stocks and bonds.

Meanwhile, Bernanke has emerged as the Fed's point man on the deflation issue. In his most high-profile appearance on the subject to date, he has been invited to discuss "Monetary Policy in Japan" by the Japanese Association of Monetary Economics in Tokyo on June 1. The speech will be closely watched, for Bernanke's antidote to the chronic problem could be key to halting the spread of this economic blight in its tracks.

POLITICAL FAILURES. The timing is especially interesting, since the architect of the Fed's strategy for warding off deflation will be speaking in Japan as the Group of Eight major industrial powers are finishing up their annual confab, this year in Evian, France.

In his November speech, Bernanke diagnosed Japan's 1% annual decline in the country's consumer price index as a "moderate" bout with deflation -- coupled disruptively with seemingly intractable structural problems such as the private sector's "massive" financial woes and a heavy load of government debt.

As a result, the Bank of Japan was reluctant to underwrite a government policy of buying Japanese bonds outright, rather than implement tough policy decisions. These bloated liabilities then became even more vicious in a deflationary cycle, as the "real" cost of borrowing rose.

Yet Bernanke sees the principal failure in Japan's efforts to cure deflation in the reluctance of the country's ruling coalition to swallow the bitter medicine of fully cleansing banks and corporations of their bad debts through massive write-offs. The political costs of such remedies would have been bankruptcies and unemployment boosts.

CRANK UP THE PRESSES. At the time, Bernanke contrasted the U.S. experience with that of Japan, pointing out that the U.S. financial system and corporate sector is much more robust, and that the government's debt load is presently much lighter as a percentage of GDP. Yet he acknowledged that complacency would be a mistake, as neither Japanese nor U.S. forecasters had anticipated a deflationary episode in Japan.

Bernanke's policy prescription? Preventing an aggregate fall in demand and prices in the first place has become a top priority for the U.S., though obviously it's too late for Japan. Outlining three steps, Bernanke said the Fed should maintain a "buffer zone" on inflation, ensure the integrity of the financial system, and act more preemptively and aggressively in cutting interest rates. This approach should be combined with stimulative fiscal policy -- a comprehensive approach already under way with the recent tax cuts.

Once deflation has taken hold, the Fed Governor's first treatment would be to aggressively crank up the monetary printing presses. Bernanke also recommends expanding the "scale of asset purchases or menu of assets" the central bank could snap up, thereby delivering additional liquidity to the financial system, or making low-interest loans to the banking system via the Fed's discount window, collateralized against a variety of private assets such as corporate bonds.

HALF MEASURES. Similar to the Japanese central bank's approach, the Fed could also revert to a zero rate policy, or even place a rate cap on longer-term Treasuries maturing within the next two years. Finally, in tandem with flooding the markets with money, the Fed could, in an extreme case, purchase foreign assets -- engineering a de facto weakening of the dollar.

That last tactic smacks of a recent covert intervention by the Bank of Japan, which bought dollars and Treasury securities in an effort to push down the yen and thereby mitigate the impact of the currency's rise on the country's exporters.

Bernanke's Tokyo audience will be all ears, though officials there could well claim they've already implemented many of these policy steps. Bernanke is likely to reply that they haven't yet gone far enough. Though the International Monetary Fund does not see risk of deflation spreading globally, it did recently target the economies of Hong Kong, Taiwan, and Germany as being the most at risk. Uncle Sam and the other world economic powers would clearly prefer that deflation be thwarted in Japan before it becomes a worldwide epidemic. Wallace is a senior market strategist for MMS International


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