In light of a quick response from the U.S. to the economic downturn in the form of quick interest rate cuts and stimulus spending, many fear that inflation is imminent. However, based on Japan’s financial crisis and subsequent deflation during the 90s, we cannot rule out deflation.
Some are claiming that if deflation were to happen, it would have already become apparent in the wake of the housing bubble burst and recession. However, according to a recent report from Capital Economics, this was not the case for Japan where deflation took nearly nine years to set in.
In fact, the U.S. is showing many of the same signs that the Japanese economy did during the first half of their lost decade. Despite having slashed interest rates in just two years in the U.S. as opposed to the six years it took in Japan (chart 1), the U.S. economy is tracking Japan’s 1990s behavior in all of the key indicators.
Despite quicker and more aggressive fiscal and monetary responses by the U.S., Core CPI inflation and Average Earnings (%y/y) have behaved nearly identically to Japan’s for the first five years after asset price bubbles burst.
Furthermore, our unemployment rates have spiked much more rapidly. Unemployment in Japan was a slow increase of about three percentage points over the course of a decade. In the U.S. on the other hand, unemployment immediately jumped five percentage points in only three years (Chart 6).
Additionally, the initial recession after the bubble burst in the U.S. was much deeper than the one Japan experienced in 1989 and 1990 (Chart 5). And Japan experienced periods of short, rapid growth during their lost decade. The end of 2011 will mark five full years after the housing bubble popped; GDP growth will be 2% or less in 2011. The U.S. is already half way through our own lost decade. If we can learn anything from Japan’s experience, it’s that deflation cannot be ruled out.