Is the US in danger of Japanese-style deflation – and what does this mean for investors?

A divided Congress, unable to agree on a stimulus package, could set the US economy down Japan’s path
Currently popular assets, such as tech stocks, could then underperform cash and long-maturity Treasuries, a lesson Japanese investors have had to learn

Paul Podolsky

Published: 3:30am, 29 Oct 2020

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In 2000, I sat in a bland grey Prague conference room opposite officials from Japan’s Ministry of Finance. We were attending a G7/International Monetary Fund meeting. I asked if they thought the US and Europe could avoid Japan’s protracted deflation. None of them could suppress a smile. “Unlikely,” said one.

So far, these officials have been wrong, but just barely. European inflation is around zero, and US inflation is a bit above 1 per cent. Could Japanese-style deflation hit the United States? It could, particularly if Congress struggles to implement meaningful, long-term fiscal stimulus.

For savers, deflation means the assets that are so popular right now – tech stocks – could underperform the assets no one wants to hold, like cash and long-maturity Treasuries, a lesson Japanese investors have had to learn.

Lower US inflation will occur if demand is weak and goods supply ample. To stimulate demand, typically the Federal Reserve lowers policy rates. In response, the private sector borrows and spends – usually on houses and cars – and the economy picks up. However, once policy rates are zero, the Fed can’t lower interest rates further.

The Fed can buy assets. This forces money into the hands of asset holders, which drives stocks and bonds higher, but doesn’t get money directly into the economy. The only way to do that is through effective fiscal policy (direct spending, not tax cuts), which means that the Fed, Treasury and Congress need to work together.

Federal Reserve chair Jerome Powell and US Secretary of the Treasury Steven Mnuchin greet each other in Washington on June 30, after testifying before the House Financial Services Committee on the response of their departments to the coronavirus pandemic. Photo: EPA-EFE

Historically, bipartisan agreement for big fiscal pushes has only come in the midst of obvious national emergencies, like the attack on Pearl Harbour or Covid-19. When Covid-19 fades, as it eventually will, the risk is that a divided Congress will not agree on meaningful fiscal policies. There are signs we are already seeing this, such as its inability to agree on a supplementary stimulus.

Inflation is the change in the average of the prices of what we buy. This mostly boils down to labour, commodities and shelter. If the supply of these items increases, absent a surge in demand, prices will fall. It is not hard to envisage that occurring.

Take labour. The ability of technology to integrate emerging-market workers into the global economy has been deflationary. While this has been available to large corporations for years, it is now increasingly available to small businesses via portals like Indeed or Upwork.

Labour automation via robots will also accelerate. In terms of energy, evidence of global warming may boost consumption of alternative energy, effectively increasing energy supply and decreasing demand for oil. Finally, pandemic-related moves to work remotely could radically revamp pricing structures for shelter.

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Equities, which is what most investors hold, do well when inflation is low but positive. For much of the 20th century, investors struggled with unanticipated shifts higher in inflation, particularly in the 1970s. Inflation destroys the value of cash by eroding its real purchasing power and hurts stocks. Bond yields tend to rise as investors demand compensation for higher inflation; rising bond yields depress equity valuations.

For much of the 19th century, however, investors struggled with unexpected downward shifts in inflation. In one of the worst 19th century deflations, US prices fell by almost 2 per cent a year from 1873 to 1896. Falling inflation boosts the relative attractiveness of holding cash, which then makes taking the additional risk of stocks less attractive.

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This is why Japan’s experience is worth noting. Conceptually, a government with fiat money – a government-issued currency that is not pegged to the price of a commodity such as gold – can create any level of nominal gross domestic product it wants. The fiscal authorities can borrow and spend, and the monetary officials can print money (literally create zeros in an electronic registry) and buy the bonds issued.

Yet, in Japan, that theoretical possibility never became a practical reality in enough magnitude to drive inflation steadily positive due to bureaucratic infighting, similar to that which is now evident in the US. Japanese equities are in a 30-year bear market. By contrast, Japanese bonds have returned 2.8 per cent a year.

Pedestrians walk past a shuttered department store in Tokyo’s Nihombashi area amid the coronavirus pandemic in April. Photo: Getty Images

The US bond market is now forecasting sub-2 per cent inflation for a decade, which one can see by comparing the prices of a nominal and inflation-protected security of similar maturity. In other words, the market is predicting the Fed will fail to meet its target. Meanwhile, at present, the US Congress cannot coalesce around meaningful fiscal policy.

Perhaps a Democratic sweep of the US elections will change the odds of meaningful fiscal policy, but the possibility of a Japan-like outcome for the US remains substantial, and the implications for US and global households are significant. The investment returns they earn will be much lower than many investors are expecting.

Paul Podolsky is an investor and the author of Raising a Thief. For 20-plus years, he worked on Wall Street, most of the time with Bridgewater Associates

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