Cecchetti Plays Down Deflation Fears

Stephen Cecchetti in an article in this morning's Financial Times attempts to persuade us that deflation fears are overdone. Cecchetti is a serious economist and his arguments bear consideration, so what are they? He differentiates between falling prices in one or more sectors, and a generalised decline in prices, only the latter, clearly, constitutes deflation.

Deflation is when prices are falling on average, not when some prices rise and some fall. The objective of most central banks is to stabilise prices on average, which means that some prices will be falling while others are rising.People running the companies whose product prices are falling are not going to be happy about this. They are going to whine that something needs to be done about this "deflation".

This is generally true, although it isn't necessarily true that the relevant companies will necessarily 'whine'. It is important to differentiate here between sectors such as technology where a decline in prices can produce (depending on elasticities) rising revenues and profits, and declining industries (like steel) or agriculture and raw materials where declining world prices produce discomfort in some sectors. There are non-monetary solutions available for this latter class of problems like protectionism and subsidies (both currently practised by the Bush administration), although whether these are adviseable or desireable is another matter. as Cecchetti indicates since the CPI is an average some prices will always be always be rising less than the inflation level. Logically then , as this level approaches zero, some prices must be declining. So where is the worry, well:

As long as central banks do not allow sustained, steady deflation, we shall be fine. After decades of suffering from inflation of 5-10 per cent, we are now close to price stability. Let us congratulate policymakers for providing the foundations for stable long-term growth.

OK, fine. But before we start cracking open the champagne and congratulating our politicians central bankers, perhaps we might stop to consider the 'as lomg as.....' caveat. Because isn't that just the problem, isn't this what those who are worried about inflation Krugman, De Long, Roach (yours truly) are worried about, that we might drift into sustained, steady deflation (I think we understand the difference from sectoral problems and the statistical properties of an average, thanks. Oh, and by the way we are 'preoccupied', not 'whining' - isn't this what dogs do, there's really something I find disagreeable in the use of this metaphor). So what is the explanation of why this sustained, steady deflation is unlikely:

Related to these deflation fears is concern that monetary policy has become ineffective. People maintain that interest rate cuts no longer have the impact they once did and that, with the federal funds rate at 1.25 per cent, the Federal Reserve is going to run out of ammunition pretty soon. I do not believe either argument. Monetary policy has always acted through corporate investment, consumer borrowing and the current account and it still does .......generally they [these effects] are alive and well.

I'm sorry, this argument doesn't convince, corporate investment is moving to China, and (perhaps) in the case of services to India, consumer borrowing is growing alright, but the negative effects of this on the current account is only to clear. Most notably the dollar isn't adjusting sharply to compensate. The big question then is, why is this? Here Cecchetti is silent, since clearly the explanation needs to be looked for globally, and it is here that the limitations of a US centric, 'business as usual' approach are most apparent. The dollar is not falling anywhere far, fast, because there is no-one else about to go up. This is the force of Roach's points about the lack of a rival growth engine to pull the train, and the global character of the deflationary headwinds (strangely, now I think of it, the word globalisation doesn't appear anywhere in the article. Perhaps this is why he things the traditional monetary effects are alive and well, although in fact many of the 'changes in the system of financial intermediation ... that allow many borrowers to bypass conventional banks' (and which are his specialist area) are among the processes most affected by globalisation.

Going back to the current account problem. One traditional response would be to lower interest rates to drive down the currency. But wait a minute, interest rates are already at 1.25%:

What about the zero nominal interest-rate floor, the point at which central banks supposedly become impotent? Listening to officials from the Bank of Japan, you would think that once they set their interest rate target to zero, there was nothing else they could do about stagnant growth and falling prices. Again, I do not believe it. We all know that whatever a central bank does, it does it by adjusting its balance sheet - buying and selling securities and making loans to commercial banks. And, uniquely, the central bank can expand its balance sheet without limit. None of this changes when the nominal interest rate hits zero. Monetary policymakers can still buy securities, enlarging their balance sheet, increasing the amount of money in the economy and eventually driving prices up. These "unorthodox" methods are not all that mysterious. Federal Reserve policymakers know how they work and will use them decisively if and when the time comes.

Again, everything seems fine, except that, well listening to Cecchetti you would think that once the BOJ had set their target rates to zero, then they had done nothing else about stagnant growth and falling prices, you would think they hadn't thought about adjusting their balance sheet - buying and selling securities and making loans to commercial banks. Listening to Cecchetti you would think they hadn't done any of this, but you wouldn't be right. On this topic I'm afraid Cecchetti is simply ignorant, and is showing his ignorance in public. If this is meant to re-assure, then I'm afraid it might have the opposite effect. In fact the BoJ has been systematically raising it's monthly rinban buying operation of Japanese Government Bonds (JGBs) from ¥400 billion to ¥600 billion to the current ¥1000 billion (a figure which may be about to go up again sometime soon). And again Cecchetti is wrong, the central bank cannot simply 'expand its balance sheet without limit' as the Japanese have discovered to their cost: the ratings agencies start downgrading you. Ignorance about Japan is perhaps our main enemy right now, so I'll take the liberty of quoting Morgan Stanley's Japan commentator Takehiro Sato at some length:

We had thought the BoJ held a monopoly on "ZIRP" (Zero Interest Rate Policy), but the FRB rate cut on November 6 suggests that macro policy globally may be heading into the "World According to ZIRP." The Japanese economy can be viewed as the front runner in a global deflation race with no apparent end. The central banks of other industrialized economies will gradually come to understand the BoJ’s struggle, having completely exhausted traditional policy measures. Central banks fought inflation through the mid-1990s, but the battleground has changed to the uncharted territory of deflation. In some respects, it is positive that overseas policy authorities and academics will begin coming to terms with the tough challenges of fighting deflation in a ZIRP environment, which is something that only Japan has experienced until now. The BoJ should benefit from overseas financial authorities giving serious consideration to the implications of a "purposeless" policy of quantitative easing (basically a zero interest rate with a ¥15-20 trillion reserve floor) should the FRB and ECB move into the ZIRP realm. The unfavorable scenario for the BoJ would be foreign central banks having unexpected success with quantitative easing and such easing ironically spurring a recovery for the global economy. In this case, the BoJ is likely to face criticism for being slow on the draw with policy action.

Japan’s experience thus far suggests slim chances for the latter scenario. Once the policy rate drops into the lower 1% range, the game is already over for monetary policy. While monetary policy can be effective in restricting total demand when necessary, it lacks the wherewithal for demand creation. Since the elasticity of real money demand from nominal rate fluctuations rises to an extreme level with a zero interest rate, the short-term money market endlessly absorbs liquidity supplied by the central bank, just like spraying water in a desert. Liquidity never makes it to the real economy. This can also be understood in terms of zero opportunity costs for reserve deposits. There is no pain from holding an infinite amount of reserves ("no pain, no gain"). Additionally, the BoJ has gradually raised its liquidity provision mechanism of Rinban operations (which is equivalent to coupon pass). However, these operations wind up strengthening flattening bias on the yield curve, and actually contribute to deflation expectations through the financial market’s expectation formation dynamic. ZIRP poses the danger of getting caught in a policy trap that cannot be easily escaped. Other central banks should give careful consideration to the siren call of ZIRP.

In retrospect, efforts in 1995 to reenergize markets by taking stronger-than-expected additional monetary easing were a significant milestone on the road to ZIRP. In fact, the economy itself, and not only financial markets, shifted from inflation to deflation expectations from 1995. Data for various key macro parameters, such as relationships between short-term rates and the long-term/short-term rate spread and the current account surplus and long-term rates, show a major dislocation occurring in 1995. Nearly two and a half years have passed since the IT bubble collapsed (around 10 quarters), and the US is approaching the point at which the deflation impact from Japan’s stock price collapse started to manifest itself in the real economy.
Source: Morgan Stanley Global Economic Forum
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The argument which Saito presents and which Cecchetti ignores is that of expectations. You see, it seems the deflation turning point comes when consumer and corporate expectations shift to a deflationary scenario, then it becomes logical to postpone both investment and consumption decisions, thus giving traction to an environment of secular deflation which may prove extremely difficult to pull out of, especially if the deflation turns global. This postponment can give rise to a situation where an economy's productivity grows more rapidly than growth in the real economy on a sustained basis, the so-called output-gap scenario. Unfortunately Cecchetti does not let us know his feelings on these arguments, and since they are among the most forceful explanations as to why the deflation danger may be real, they certainly merit consideration.

As to why all this might be happening, there is an almost total silence. Regular readers of this column will know I have tried to spell out three factors which may help understand why we have a global deflation watch call out right now. Firstly is the 'industrial revolution' currently taking place in China. A 'revolution' produced by massive internal restructuring, with a huge surplus population driving down real wages to such an extent that China itself is experiencing deflation. This deflation - due to the sheer magnitude of China's population - is then being systematically exported to the rest of the world. Secondly we are living globally through what could be called the 'third technological revolution' of the modern epoch (the invention of agriculture 10,000 years ago did, of course, constitute a technological revolution, and since the current 'revolution' is informational it is not necessarily an industrial one) this is driving down prices globally in the technology sectors and the strategic nature of such sectors (GPT's and all that) means that falling prices here are transmitted across the OECD economies generally. Thirdly, all the OECD country populations are ageing. The proportion of the working population in the 50-65 age group is growing steadily, and this is producing a subtle shift in the relationship between saving and current consumption along with a growing sense of price importance (the Coale/Hoover hypothesis) producing a bottom line which tends towards a deflationary environment.

Has Cecchetti made his case. I leave the reader to decide.

Takenaka Tug-of-War with Banks Continues

Japan's Financial Services Agency has made public for the first time the fact that it believes bad loans at the country's banks are Y13,000bn ($109bn) greater than the banks say. The number here is not especially important in itself, it is however 36% higher than the banks own figure. This would seem to indicate a determination on the part of Takenaka and his team. One other confirmation of this assessment might be found in the fact that Tokyo stocks lost ground this morning, as the banking sector suffered the consequences of the increased assessment of their bad loan holdings:

The decision to release the figures is the latest step to strengthen banking supervision in Japan by Heizo Takenaka, pictured, the former academic and reformist cabinet minister who took charge of the FSA last month. It follows the release of a package of banking reforms late last month by the FSA, the country's main financial regulator, that requires bad loans fall by half by March 2005. The publication of the FSA's estimate rides roughshod over the sensitivities of senior executives at the country's largest banks and is likely to further sour relations between Mr Takenaka and the banks' boards of directors. In the FSA's assessment, Mr Takenaka said bad loans were Y47,000bn compared with the banks' figure of Y34,000bn.

The extent of bad loans and loan losses could grow further after the FSA completes another set of inspections of the banks - likely to begin in February - during which it will apply even stricter criteria. The figures released at the weekend were based on the FSA's latest inspection for April 2001 to March 20002. At that time the regulator was run by Hakuo Yanagisawa, who was sacked and replaced by Mr Takenaka. Banks review non- performing loans and loan-loss reserves twice a year. The FSA's February audit will help ensure the banks are accurately conducting their own reviews.
Source: Financial Times
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The benchmark Nikkei 225 average lost 1.8 per cent to 8,534.89, while the broader Topix index was off 1.9 per cent to 845.98. The banking sector was off 3.5 per cent, with Mizuho Holdings, the world’s biggest bank by assets, off 7.7 per cent to Y156,000. UFJ Holdings was down 8.9 per cent to Y143,000, while Sumitomo Mitsui was off 6.3 per cent to Y418. Adding to the gloom was data released Monday morning that showed Japan’s current account surplus – a broad measure of trade in goods and services – slipped 6.8 per cent in September, for the first time in a year. The data adds to mounting evidence that the country’s fragile export-led recovery has peaked. Japan’s top exporters lost ground on the news, with Sony shedding 3.3 per cent to Y5,020 and Toyota Motor off 1.6 per cent to Y3,090. Honda Motor lost 4.9 per cent to Y4,100 and consumer electronics maker Sharp was off 2.1 per cent to Y1,080. Semiconductor maker Advantest was 4.3 per cent lower to Y4,680 and rival Tokyo Electron was down 5.4 per cent to Y5,010.
Source: Financial Times
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More WiFi Boosting Technology

An interesting piece from the NYT about a start-up company which plans to announce new antenna technology on Monday which, it claims, can expand the limits of wireless Internet, providing access to hundreds or even thousands of portable computer users at distances of more than 2,000 feet within buildings and about four miles outdoors. The technology, which stems from 1950's research for so-called phased-array antennas for military applications, makes it possible to electronically steer numerous radio beams from a single point. Focusing the beams increases their signal strength, and using large numbers of them greatly increases the antenna's traffic capacity:

The antenna uses the 802.11 technical standard, also known as Wi-Fi, which is currently limited to providing wireless Internet access to several dozen users within a few hundred feet of the transmitter. Wi-Fi is increasingly common in offices, airports, places like Starbucks shops and even in a growing number of households.

Executives for the start-up company, Vivato, based here, said they expected their technology to be especially suited to office buildings because it would enable so many more people to use a single Wi-Fi Internet connection simultaneously. "We will change the way people think about the physics of Wi-Fi," said Ken Beba, the chairman and chief executive of Vivato.

"Most people don't understand it, but the antenna is the most important part of any radio," said Craig Mathias, president of the Farpoint Group, a wireless industry technical consultant. Analysts who were briefed on Vivato's plans said that the technology was intriguing, but they warned that it had yet to be proved commercially —particularly in the corporate, or enterprise, settings that the company sees as its main targets.
"The entire market is scrambling to get some traction with the enterprise customers," said Sara Kim, a wireless industry analyst at the Yankee Group in Boston.

The idea of adding capabilities to antenna systems is not new for either wireless data or voice communications. Silicon Valley companies now pursuing such ideas include ArrayComm and SkyPilot. But analysts say Vivato is the most aggressive in making use of the inexpensive Wi-Fi capabilities that are already part of many desktop and portable computers, as well has hand-held Palm and other devices. Most other more advanced systems in use today require adding a special networking device to the user's computer. "The key magic here is our ability to talk to the standard 802.11 clients," Mr. Beba said. Vivato's antenna is meant to be placed in the corner of a large office and used to provide wireless service throughout a building. In contrast to many other companies that are trying to extend the range of 802.11 by creating meshes of access points, Vivato takes a more centralized approach by transmitting a series of beams from the antenna.
Source: New York Times
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Pros and Cons of Euro Entry

In this timely piece, Morgan Stanley's Fatih Yilmaz and Stephen Jen do some options call accounting on the pluses and minuses for EMU participation on the part of the UK and Sweden. They rightly conclude that, seeing what we are seeing, the value attached to waiting just went up, dramatically. As they point out both the UK and Sweden are already members of the EU, and, in that capacity, enjoy all the trade benefits that are afforded to all EU members. In addition the benefits of joining the EMU should be distinguished from those of being EU members. On the plus side, the key benefits of joining the EMU seem to be: firstly, a reduction in the transaction costs of trading with and investing in the other EMU member countries fall, the cost of raising capital should also decline towards that of the rest of Euroland, secondly, in theory, "monomoney" in Euroland should enhance price (and wage) transparency, which in turn should lead to greater competition in the product market and the labour market (it's important to note the 'in theory part here, since at present it might seem that this transparency, absent labour market flexibility, is leading to a naive inflationary coupling effect in the Southern zone of Europe). Thirdly, any potential adverse effects of exchange rate uncertainty on trade and investment would disappear. These benefits appear extremely thin when we start to look at the associated costs:

Joining the EMU comes with its costs. First, there is the issue of abandoning monetary independence. The use of domestic monetary policy and exchange rate adjustments for the purpose of national demand management will be lost. The size of the cost of forsaking monetary independence depends on two factors: As the effectiveness of monetary policy for adjusting the macroeconomic imbalances increases, and as the asymmetry of the responses of the member countries to economic shocks intensifies, the associated costs will be larger. Second, the Maastricht treaty imposes tight fiscal policy restrictions to fulfil several convergence criteria. With negligible large-scale regional transfers, the loss of fiscal autonomy can also have adverse impacts on demand management and economic stabilisation. Third, factor mobility and price (wage) flexibility, the vital mechanisms for adjustments in a monetary union when monetary and fiscal constraints are binding, are severely restricted in Europe. Fourth, attempts to achieve one-size-fits type Europe-wide policies can themselves generate political conflicts within Europe.
Source: Morgan Stanley Global Economic Forum
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Let me just run this again. You get to save some currency uncertainty costs, and possibly to borrow money a bit cheaper (mid-term this remains to be seen). In exchange you lose all control over fiscal and monetary policy, have to operate permanently in sub-optimal conditions (this follows from the fiscal/monetary point, look for eg at Germany right now) and face a lot of political in-fighting to boot. Seems like no-contest to me. Of course one mistake (there have been many I'm afraid) always was to create the category of EU member, non-EMU participant. But now it's too late I guess.

Who's in charge in Japan?

As I have already indicated (see blog post immediately below) there is considerable doubt and consusion about where exactly Japan is headed right now, and about what will be the real impact of Takenaka's reform programme. Morgan Stanley's Robert Alan Feldman seem to be in no doubt:

The media were wrong. A week ago, when the initial reports on the new plan for financial system clean-up were announced, the press universally dismissed the new plan as a humiliating retreat from the hardline position that Minister Takenaka had taken. Indeed, one reporter asked me if there was anything to write but an epitaph. Nothing could be further from the truth than these reports.

It is true that immediate enforcement of US standards for deferred tax treatment (DTAs -- see appendix table 1) was not in the package. However, the package did include a review of the standards (which was not even on the agenda under the previous minister), and a clear tilt toward tightening (see appendix table 2). Moreover, virtually every other component of the initial wish list IS included in the final plan, along with some enhancements. Many of these provisions are extremely strict. In addition, the final plan includes some provisions that will enhance the sustainability of the financial reform plan.

The most epoch-making part of the plan was the new concept of "special support financial institutions" (SSFIs). The plan specifies these as institutions in distress, capital shortage, or similar situations, and says that the government and BoJ will apply "special support" immediately. Such support will trigger various actions, including FSA resident inspectors and prompt removal of "danger of bankruptcy" or worse loans to the RCC or to revival funds. Once transferred, the plan calls for prompt disposal, e.g., by RCC to accelerated collection and sales of loans purchased, with prompt sale of those loans that cannot be collected quickly, creation of a market in distressed loans, and greater use of securitization and asset-backed securities market. Of course, the FSA will have to determine whether institutions fall into the SSFI category, and this cannot be done logically until after the next round of special inspections is complete -- barring unforeseen major bankruptcies. However, the SSFI concept is a powerful one.

Now that the bashing is over, there is considerable evidence that Minister Takenaka in fact has won some very important victories. Of course, much lift is still to be done, and investor skepticism will not fade easily. However, I believe that Minister Takenaka has made a very powerful start, and that momentum is with him.
Source: Morgan Stanley Global Economic Forum
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Japanese Banks Set to Slash Lending

According to the Asahi Shimbun the toughening in Tokyo's bad-loan stance is forcing Japanese banks to react. The NBL disposal program being developed under Heizo Takenaka, minister for financial affairs and economic and fiscal policy, is supposed to make banks strictly appraise loans and set aside additional loss reserves to counter bad loans expected to surface as a result. Faced with tighter regulation, banks want to jettison loans, which count as risk assets, to prop up their capital levels. Much of the press has been skeptical about the intent of this reform, this early indication suggests that such skepticism may be misplaced, after all Japanese economic and monetary policy is caught between a rock and a very hard place. In which case watch out for the backdraft (See my blog: WILL HISTORY TREAT THE NAME TAKENAKA THE WAY IT ONCE TREATED YAMOMOTO here)

Threatened by the specter of state takeover under Tokyo's new bad-loan policy, the nation's four top financial groups plan to cut loans and other risk assets by 30 trillion yen in the current fiscal year, according to bank sources. Mizuho Financial Group, UFJ Group, Sumitomo Mitsui Banking Corp. and Mitsubishi Tokyo Financial Group will all significantly reduce their asset portfolios.To avoid hanging small, deeply imperiled corporate borrowers out to dry, and to dodge heat for crunching credit, the banks plan to scale back lending to foreign borrowers and securitize loans to major borrowers.

If higher loan-loss reserves drain too much capital, their capital-asset ratios may fall below the international floor of 8 percent, which is expected to trigger a government takeover. Assets of the banking groups carrying credit risks, including loans, totaled 273 trillion yen as of March, down 28 trillion yen from the previous fiscal year. By reducing such assets by 30 trillion yen, the banks will reduce their total risk liabilities by a greater margin in the current fiscal year.The offloading of assets is expected to bolster the banks' capital-asset ratios by about 1 percentage point.The biggest cut will be at Mizuho Financial, the world's largest banking group, which plans to shed 15 trillion yen from its asset portfolio. Sources said this is two to three times the initially planned amount.UFJ ranks second with planned cuts of 7 trillion to 8 trillion yen, followed by Sumitomo Mitsui Banking, which plans to add several trillion yen in cuts to its plan to reduce assets by 5 trillion yen.Mitsubishi Tokyo Financial, meanwhile, will slash assets by 2 trillion to 3 trillion yen.
Source: Asahi Shimbun
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'FED TO HOLD FIRE', WHAT FIRE?

According to this piece in Reuters "The Federal Reserve will hold its fire over the next few months and hope the U.S. economy gets back on its feet". But well may we ask, what fire? With interest rates now at 1.25% the Fed is about done with monetary policy. According to Reuters "Economists interpreted the aggressive move by the Fed as an attempt to bolster business and consumer morale, and that the Fed is signaling its work is done by stating the risks to the U.S. economy are now evenly balanced between weakness and inflation." For Morgan Stanley's Japan economy watcher Takehiro Sato the recent Fed move is surprisingly reminiscent of Japan in 1995. The reason, the impact on expectations. Are we living in this very moment the turning point where investors and consumers begin to orient their behaviour according to deflationary rather than inflationary expectations. This 'expectations shift' even more than any detailed technicalities associated with the subsequent liquidity trap is what really does the damage, and what 1930's experience shows may be the hardest corner to turn. (NB it is after all the expectation of falling prices and near zero interest rates- the so called ZIRP - that places a lower cost on holding money, and at the same time leads to the postponment of consumption and investment decisions). Bottom line: is this now a heads I lose, tails you win scenario for the Fed? And lets not even think about all thos geopolitical headwinds out there just waiting to blow. As Reuters says, all we have left is the hope the US economy gets back on its feet. Get your fingers crossed!

The FRB rejected market consensus and went ahead with a 50bps rate cut, dropping the FF rate to 1.25%. To veteran BoJ watchers, this move is reminiscent of Japan’s monetary easing in March-April 1995. The Bank at that time had (in late 1994) been encouraging the unsecured call rate to move higher amid rising cyclical recovery momentum. Yet it was forced to switch course to monetary easing by a series of negative shocks -- the massive Hanshin earthquake in January 1995, the subway sarin attack in March, and rapid yen appreciation during March and April. With the yen sinking to the ¥80/US$ range in March and April, BoJ officials sought to head off easing pressure by encouraging the unsecured call rate to drop 75bps, a larger margin than expected by the market. Yet this strategy failed and only accelerated the timing of the transition to ZIRP. It again tried to foster an end to easing sentiment with 50bps cuts each in the call rate target coinciding with forex market intervention in July and government economic measures in September of the same year. In retrospect, efforts in 1995 to reenergize markets by taking stronger-than-expected additional monetary easing were a significant milestone on the road to ZIRP. In fact, the economy itself, and not only financial markets, shifted from inflation to deflation expectations from 1995. Data for various key macro parameters, such as relationships between short-term rates and the long-term/short-term rate spread and the current account surplus and long-term rates, show a major dislocation occurring in 1995.

Nearly two and a half years have passed since the IT bubble collapsed (around 10 quarters), and the US is approaching the point at which the deflation impact from Japan’s stock price collapse started to manifest itself in the real economy.
Source: Morgan Stanley Global Economic Forum
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