Pray for Higher Prices

So far, central banks around the world are doing an admirable job of keeping global inflation in check without choking off economic growth. Much of this success stems from their focus on the goal of fighting inflation and maintaining high employment rates. There is one central bank, however, that's been doing battle with an entirely different foe – deflation. Like a knight trying to save a princess from the clutches of a fire-breathing dragon, the Bank of Japan (BOJ) has been trying to rescue Japan's economy from deflation for most of this millennium. In its quest, the BOJ has been forced to wield some unusual weapons, and at long last, they seem to have the upper hand.

Inflation and deflation are fairly simple concepts. Inflation occurs when prices of goods rise. Deflation occurs when prices of goods fall. At any given time, prices of some goods may be rising while others are falling. For instance, over the last few years, the price of gas increased (inflationary), while the price of personal computers decreased (deflationary). In order to determine whether overall prices are rising or falling, economists evaluate the aggregate price of a basket of goods intended to represent the spending habits of consumers in a given country. The Consumer Price Index (CPI) reflects the price of this basket of goods and is the most commonly used yardstick for gauging inflation.

Central banks don't abhor inflation so vehemently that they want to do away with it entirely. In fact, most central banks would prefer moderate inflation to persistently falling prices. Modest inflation gives consumers an incentive to spend because their money will buy them less of what they want in the future. If Starbucks increases the price of a latte, your $3.00 might only buy you a grande instead of a venti if you hold off on the purchase for too long. Deflation has the opposite effect. If you expect the price of a latte to fall and can manage without a coffee fix for awhile, you might hold off on making the purchase so your $3.00 will buy you more caffeinated bang for your buck.

Inflation and deflation have similar effects on borrowing. Inflation benefits borrowers by reducing the real interest rate paid on loans. Deflation discourages borrowing by increasing real interest rates.

The primary tool central banks use to control both inflation and deflation is interest rates. When central banks are concerned about inflation exceeding their comfort level, they raise interest rates to make borrowing money more expensive and, thus, make money more difficult to come by. When falling prices are the concern, central banks can lower interest rates to increase liquidity. Theoretically, there is no limit to how high interest rates can go, but they can't go any lower then 0%. So what happens in a central bank lowers rates to 0% and deflation persists? The BOJ encountered this exact situation.

Like Guns N' Roses and Bon Jovi, Japan's economy and stock market were rocking during the 1980s. But the 1990s brought a downturn in the economy and a start of a bear market that saw the Topix Index decline by almost 75% over the next 3.5 years. The BOJ lowered interest rates significantly in an effort to jump start the economy, but the rate cuts had little effect. When Japan's inflated prices began declining, there wasn't much room left to decrease rates, and it wasn't long before short term rates hit 0%. Despite this zero interest rate policy (or ZIRP as it was known to always clever economists), prices in Japan continued to fall. Eventually, the BOJ was forced to take even more extreme measures to combat deflation. Specifically, the BOJ adopted an unusual policy known as "quantitative easing."

Under quantitative easing, the BOJ dramatically increased the amount of money available to banks for lending. This ensured there would be plenty of money to lend and interest rates would remain at 0% because the supply of available funds would be more than sufficient to meet demand. To the chagrin of the BOJ, quantitative easing didn't have much of an effect at first. The prolonged economic downturn had left most companies' balance sheets in shambles, and they weren't in any shape to take on much debt, no matter how much money was available or how cheap they could borrow. Eventually, the economy improved and companies started borrowing again. Although it took five years, quantitative easing was ultimately successful, and prices have finally begun to rise in Japan. Convinced that deflation has been defeated, the BOJ ended both quantitative easing and ZIRP earlier this year.

In short, paying a little more for your latte might seem like a strain on your pocketbook, but from an economic standpoint, lower prices are just as likely to take the steam out of your milk.