Whatcha Gonna Do BOJ?

It’s official! Japan, the world’s second-largest economy, has entered deflation. Japan’s domestic demand deflator, which measures the change in local price levels, posted a 2.6% drop for the third quarter – its steepest decline since 1958.

The culprit?

The recent economic recession! This global downturn, which resulted to a slump in commodity prices, has caused Japanese core consumer prices to print year-on-year declines for seven months in a row. As if this wasn’t bad enough, the Bank of Japan even went on to predict that the slide in consumer prices would go on for three more years!

In economics, this kind of situation is called deflationary. Deflation happens when the country’s annual inflation rate declines below zero. Decreasing prices may sounds good at first but if people expect prices to keep on falling then eventually, nobody will spend which will lead to a vicious cycle of low demand and production – a deflationary spiral.

If you think three years of deflation is an economic nightmare, well, that’s nothing compared to Japan’s ten-year deflationary struggle in the 1990’s. Time for a short history lesson my young padawan!

Dubbed as the “Lost Decade”, the years 1991 to 2001 were characterized by a massive drop in Japanese asset prices. At that time, the Yen drew unparalleled strength from Japan’s growing export market. This led to a huge build-up of cash among Japanese businesses and consumers, setting the stage for loose credit conditions, stock and real estate speculations, and eventually an asset price bubble.

And what happens when a bubble becomes too big? It pops in your face and creates a big mess! Falling equity and land prices led to tighter credit conditions since most banks were heavily exposed to these assets. And with a lot of Japanese companies financially dependent on banks, you can imagine how much damage was caused…

In order to combat this, the Bank of Japan slashed rates all the way down to, well… nothing. The Bank’s aim was to boost the economy by flooding the market with liquidity and hoped that by doing so, it would keep the economy from hitting deflationary circumstances.

However, the Japanese economy took another hit in 1998 when the government made another boo-boo. In an attempt the address the rising national debt, the government rose consumption taxes from 3% to 5%. Coupling this with a return of falling prices, the Japanese economy collapsed.

After five more years of deflating prices, the Bank of Japan decided to take another approach. Instead adjusting interest rates, they would target money supply. Essentially, the BOJ did what all other central banks do – print more money! The influx of cash into the economy worked, as it kept prices stable while helping the economy achieve modest growth.

Now with the economy wallowing in another recession, it appears that deflationary fears are back in town. Japan, as it seems, is now in dire need of a super hero that would simply blaze away at their problems.

The Bank of Japan has already done both the conventional – practically setting interest rates to zero – and the unconventional – printing a ginormous amount of money and injecting it into the economy – and yet the country still found itself in the same deflationary swamp it swam in during the 1990’s.

If the conventional and the unconventional do not work… then maybe the BOJ isn’t unconventional enough. No matter how much the bank expands its quantitative easing program, the prospect of an exit strategy is always there. Because of this, people will continue to hoard and save rather than spend the money they have. Sooner or later they know that the BOJ will implement certain inflationary measures to make sure the large amount of money it injected into the economy is controlled.

Think about it… If you were so sure that the money you are currently holding will someday double or triple in value, why the heck would you spend now?!

Perhaps it’s time for the BOJ to be bold… Perhaps it’s time to make a solid, believable case that they are determined to let inflation happen. By taking on a sensibly careless stance, they pressure consumers and businesses to spend and invest, thereby stimulating economic activity. Otherwise, another “Lost Decade” it is…