Japanese inflation and the yen

Inflation is a scourge, so you take notice whenever someone tells you they would like to see a little more of it.

The Bank of Japan (BOJ), which has been seeking every reason imaginable to end its policy of near-zero interest rates, produced a study in May 2007 titled “The Costs And Benefits of Inflation: Evaluation For Japan’s Economy.” The study is 63 pages long, filled with quantitative macroeconomics and attempts to find the “optimal inflation rate” for Japan, which the BOJ concludes are annual consumer price increases between 0.5 and 1.0 percent.

Why does the BOJ consider some inflation to be better than no inflation, or better than the deflation Japan has experienced over much of the past decade? Because, as we have discovered in several venues since July 2007, modern economies depend on credit. Any such economy has a preponderance of debtors over creditors, and inflation allows these debtors to repay their loans in a depreciated currency. The logical rejoinder is why creditors would not demand full protection from inflation in the rates they charge, and the (short) answer is twofold.

First, expected inflation often is lower than future realized inflation, especially on an after-tax basis; this has been the experience to date with the U.S. Treasury Inflation Protected Securities (TIPS) market. Second, in a world with a small number of extremely liquid creditors — Chinese exporters, OPEC states with current-account surpluses, etc. — and with aging populations in key countries, the marginal lender often is willing to accept a lower rate in exchange for the safety of government bonds.

A second reason the BOJ regards non-zero inflation as optimal is a concept most of us forget about after Economics 101 — the demand for cash balances. If inflation induces preemptive buying, or the conversion of cash into assets before the cash depreciates further, deflation does the opposite. Savers are rewarded both for holding on to cash and by cheaper prices tomorrow. Think of your own experiences in consumer electronics: You know whatever you buy today you will be able to buy for less tomorrow.

That incentive, spread across an entire economy, encourages savings over consumption and makes low nominal interest rates completely ineffective as a tool of economic stimulus.