This Is Reflation
. . . not Japan-style deflation.


David Malpass

The stock market rally in the U.S. is a pleasing sight. Equities are now pricing in the Bush tax cut, extending the repricing that took place when the Iraq uncertainty diminished. The tax cut was bigger, more growth-oriented, and earlier than almost any expectations — and the stock market approves.

In the coming months, the economic outlook is going to improve, in step with the equity rebound. While speeches by Federal Reserve members have fueled deflation expectations, other factors — the weaker dollar, the tax cut, and coming oil shipments from Iraq — should outweigh this downbeat talk.

There’s too much concern that the U.S. is heading into deflation. U.S. deflation was a policy problem in the late 1990s and caused the global recession of 2001. However, the U.S. departed sharply from Japan’s deflation path in 2001 and we’re now well into a reflation process. In the U.S. — unlike Japan — the currency retraced its course, real interest rates became negative, and tax rates were cut sharply.

In 2001, I did write with deep concern about the analogy between Japan’s deflationary boom of the late 1980s and the state of the U.S. economy in the late 1990s. Here were my comparisons:

Like Japan, the U.S. had fostered a super-strong currency, attracting over-investment, causing a boom, and setting the stage for deflation.

As in Japan, equities had rallied to an extreme valuation. The Nikkei rose 208 percent between the 1985 Plaza accord accepting a strong yen and the December 1989 equity peak 4.4 years later. The S&P 500 rose 102 percent between the dollar-strengthening 1996 “irrational exuberance” speech [of Alan Greenspan] and the peak in March 2000, 3.3 years later.

As in Japan, equities crashed, investment stopped, and unemployment rose.

As in Japan, bond yields fell sharply as deflation expectations settled in. Since the equity peak, U.S. 10-year bond yields have fallen to 3.3 percent from 6.3 percent. In the three years following the equity peak, Japan’s bond yields fell to 4.25 percent from 7 percent and proceeded to 0.6 percent subsequently.

Unlike the yen in Japan, however, the U.S. dollar appreciated less, stopped appreciating sooner after the equity peak, and returned to its historical level. That translates to less deflationary pressure.

Unlike what happened in Japan, real short-term interest rates in the U.S. became negative within 29 months of the equity peak. Japan’s short experience with negative real interest rates occurred almost eight years after its equity peak and was quickly erased.

Unlike the Japanese government, the Bush Administration achieved three major tax cuts within three years of the equity peak, whereas Japan has continued raising tax rates. Over last weekend, Japan’s Tax Commission contemplated a VAT tax increase to 10 percent from 5 percent despite Japan’s decidedly unfavorable experience with tax increases in both 1991 and 1997.

That’s just too many “unlikes” for this to be anything like a Japan-style deflation. We’re reflating. And the economic outlook is only going to brighten.

— Mr. Malpass is the Chief Global Economist for Bear Stearns.