Deflation’s back in Japan–and why investors should care

Deflation has returned with a vengeance in Japan.

And we’re not talking about some short-term dip in prices either.

 The Bank of Japan is forecasting that prices in Japan will fall by 1.5% this year, by 1% in 2010, and by 0.7% in 2011.

So much for any recovery in the Japanese economy.

Deflation is indeed a symptom of the woes in the Japanese economy. It’s created by excess capacity that drives down prices since companies are willing to cut prices to keep factories running at even partial capacity. It’s a sign that Japan’s export-based economy is getting killed in competition with cheaper Asian exporters such as China and Korea. And it indicates that Japanese companies facing slow demand aren’t investing in new capacity or hiring more workers.

But a period of prolonged deflation like Japan has suffered during long patches of the last decade and looks like it will suffer again for an extended period as the country moves from the “00s” to the “teens,” isn’t just a reflection of an economy’s woes. Deflation in this setting itself creates problems. For example, once consumers and CEOs become convinced that prices will keep falling they have a built in excuse for putting off buying decisions. Everything will be cheaper in the future, right?

In addition, if prices are falling, low risk investments paying seemingly ridiculously low interest rates become reasonable choices. If you’re money is safe, it will appreciate in value as prices fall even if the yield is 0%. This discourages risk-taking and saddles the country with a vast pile of under-performing investments—a problem for a rapidly aging country such as Japan facing huge future expenditures.

What does all this mean to a U.S. investor? Read more

Inflation or deflation danger ahead? The markets say, Yes, but not which

Call it the great inflation vs. deflation battle.

On the one side, the U.S. TIPS market. In the last few months demand for Treasury Inflation-Protected Securities from investors worried about a resurgence of inflation has reduced supplies of the bonds at Wall Street dealers to a three-year low.

On the other side, Japanese investors. Japan bought a net $105 billion of U.S. government debt in the year to August. That’s even more than China bought during those months. The 17% increase in Japanese holdings in 2009 will only pay off if the U.S. experiences a prolonged period of deflation that drives down the yield and drives up the price of 10-year and longer U.S. Treasury debt.

One of these opinions has to be right, eventually, but it’s dangerous to assume that either has an inside track on the direction of inflation/deflation in the short-term. Investors always tend to see the future through lenses tinted by their experience of the past and that’s exactly what’s going on here. Read more