Lessons From Japan’s Lost Decades

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from NCPA,

Since the beginning of the financial crisis, the Federal Reserve (FED) has pursued an aggressive expansionary monetary policy to support easier lending and borrowing. However, inflation, which remains far below the Fed’s target of 2 percent, has led many economic analysts to believe economic stagnation could be a future consequence of monetary imbalance.

Bearing witness to this problem is Japan, which has been experiencing deflation for almost three decades. Japan serves as valuable case study for analysts to draw conclusions about the nature of money:

– Economists found that prices in Japan have not increased since the mid-1990s.
– Their interest rates have remained low for decades without putting upward pressure on prices.
– The growth of M2 money supply (which includes savings deposits, money market mutual funds and any form of money that is not necessarily as liquid but can still be turned into cash with relative ease) fell sharply at the beginning of the 1990s and has remained very low.

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.

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