Saturday, 21 February 2009

Japan and the zero rate bound

Here are two graphs (click to enlarge) about Japan over the past 30 years or so. The bottom one is the inflation rate, the salient point being that is has been negative, i.e., deflation, for quite a lot of the past 10 years. The top one shows the Bank of Japan's interest rate, which has hit zero (recall that a negative nominal interest rate isn't possible as people would be better off holding cash under their mattresses if necessary). Even at a zero nominal interest rate, negative expected inflation means that the real rate of interest is positive. The worrying thing then is that there may be some kind of deflationary spiral occurring: too high a real rate of interest could mean that spending falls further, and deflation becomes worse, increasing the real rate of interest further, etc. Policy makers are concerned that something similar could occur here, and avoiding some of the perceived mistakes of the Bank of Japan is seen to be vital. For example cutting interest rates to zero was delayed in Japan, and the mometary authorities here and in US have been more aggressive about rate cuts.

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