Deflation Isn't An Export; Crazy Talk Is

By: Michael Ashton | Mon, Jun 3, 2013
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We are once again witnessing the market effects of a deficit of basic knowledge of economics. This is, of course, no news in itself: the list of economic conceptual errors, to say nothing of forecast errors, made by market participants over the last decade is long enough to constitute an entire course of study at an accredited college. But the current misunderstanding is somewhat bothersome because it requires only a rudimentary level of common sense to see that it cannot be so; therefore, the fact that this misunderstanding persists is a sign that people aren't even bothering to think about whether the received wisdom is correct.

The question concerns Japan, as so many questions soon will. The statement is made that the aggressive quantitative easing by the Bank of Japan is "exporting deflation", and is thus the profligate monetary policy of Japan creates the risk of declining inflation domestically.

To see how bankrupt (no pun intended) this thinking is, simply perform the following thought experiment. Suppose country A can cause deflation in country B by easing monetary policy aggressively. It must also be true, then, that country B can cause deflation in country A by easing their policy aggressively. Therefore, the best strategy must be for both country A and country B to ease aggressively, since that way they will both get the benefits of monetary policy easing but both will deflate.

Obviously, that's lunacy! In this two-country case, there is much more money and yet much lower prices. This can only true if monetarist theory is completely wrong.

Let's try a slightly-more-sophisticated version of the same confusion. Instead, we make the statement that country A can cause deflation in country B by easing policy relatively more aggressively than country A. But this still creates gains, because once country B starts to ease aggressively, country A can also ease aggressively as long as they ease less aggressively, and experience falling prices along with the other supposed rewards of monetary policy. Again, this is clearly nonsense (although a little less clearly).

This is another version of the confusion of the real/nominal confusion. In this case, people observe that the country which is more aggressive in easing will tend to see its currency decline. This is true, and it is also true (as a separate statement) that a declining currency tends to increase inflation and a rising currency tends to decrease inflation. This is where the confusion sets in: by easing aggressively, the BOJ is causing the dollar to rally - although it declined sharply today - and making investors think that will pressure our domestic inflation lower.

But where did the money go?

It is true that if the US dollar rallies then, all else equal, our domestic inflation will decline. But in this case, all else is assuredly not equal. In this case, there is much more liquidity in the system as a whole. And the effect of that liquidity swamps the effect of the FX change. I used to use a simple regression model of core inflation that included both year-on-year changes in FX and M2, lagged appropriately (along with rosemary, cumin, tarragon, and some other spices). The coefficient for the change in M2 was 0.36: that is, a 10% change in M2 would, all else equal, push core inflation up 3.6%. The coefficient for the change in the dollar index was 0.014: a 10% rise in the dollar would cause core inflation to decline 0.14%. Since these two effects typically offset each other to some degree, monetary policy is more effective in pushing prices higher if you're the only central bank doing QE...but not much more effective.

Because historically the crazy monetary policies have been pursued by countries in isolation, which have seen their currencies crater while their inflation went to the moon, many investors have incorrectly conflated the two events. This is one reason that some traders have been expecting the dollar to collapse for some time now. But if everyone is pursuing QE, then the effect on the currency is indeterminate (not to mention unstable). The only reason we're seeing the Yen depreciate is that they are significantly more aggressive, for now, than the rest of the world is in pursuing QE.

So in short, Japan is "a bug in search of a windshield": yes. The Bank of Japan's aggressive QE will cause inflation in Japan: yes. The depreciation of the Yen will "export deflation" to the rest of the world: no. In fact, the BOJ's action will raise the price level in the rest of the world, although less than it will raise its own price level because the currency move will offset a small part of the liquidity effect.

Now, I am sure that someone will object that this violates Purchasing Power Parity, which suggests that the A-B currency pair should change exactly enough to offset the difference in price-level changes in countries A and B. My two quick observations are: (1) PPP is useful theory but doesn't seem to describe the real world (see the Wikipedia entry on PPP for some evidence and objections), and (2) if PPP is right, then exporting deflation is also impossible. According to PPP, the BOJ QE would have no effect on our price it's not a very effective objection to my argument that "exporting deflation" is crazy talk.


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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