Harding directed me to the example of Belarus, which like Japan has a falling population in recent years:

And yet Belarus has lots of inflation:

Not as bad as the 100% inflation of 2012, but still running around 10% per year in recent years, despite a falling population.

So why do demographics cause deflation in Japan but not Belarus?  Simple, demographics don’t cause deflation in Japan, or anywhere else.

If you have the right model of money, the world is a much less confusing place.

Just a couple of months ago, pundits were writing off the Bank of Japan, and particularly Kuroda’s policy of 2% inflation.  Now things are looking much more positive for the BOJ.  Since plunging on the night of the Trump election, the Japanese stock market has taken off like a rocket.

It’s not hard to understand why—the yen has been in almost free fall, down from about 100 to the dollar to 118 today.  To put that into perspective, back in April 1995, the yen was at 84 to the dollar.  As recently as September 2012, right before Abenomics was announced, it was at 78 to the dollar.

But those numbers don’t even come close to showing what’s going on with the yen. What really matters is the real exchange rate.  And since 1995, Japan has had an inflation rate that ran almost 2% a year lower than in the US.  The US CPI is up by more than 57% since 1995, while the Japanese CPI is barely changed.  Thus the real exchange rate for the yen has gone from 84 in 1995 to something like 180 or 185 today.  At these levels, the exchange rate is a gold mine for Japanese exporters, which explains why the Japanese stock market is doing so well.

The big puzzle here is why PPP is failing so abysmally in terms of explaining the dollar/yen exchange rate.  Generally when a country has persistently lower inflation than the US, its exchange rate tends to appreciate of time, and vice versa.  Thus the Swiss have low inflation and the Swiss franc trends upwards.  The Brazilians have high inflation and the Brazilian real trends downwards.  And over the very long run that’s true of Japan as well.  I recall when the yen was 350 to the dollar.

But since 1995 the yen has depreciated dramatically, even while Japan has had inflation rates that are roughly two percent less than the US.  Of course during this period Japan has had much lower nominal interest rates than the US (at least the Fisher effect works!), and the yen has generally been expected to appreciate (due to the interest parity condition).  Thus we’ve had a 21-year period where investors expected steady appreciation in the yen, and (on average) they got the exact opposite.

Going forward, one of two things will happen.  Either the BOJ will persist with its inflation policies, or it will not.  If it does persist, eventually investors will have to throw in the towel and admit that they were wrong about Kuroda.  The yen will no longer be expected to appreciate, and the level of Japanese interest rates will be much closer to US rates.

Or, the BOJ will abandon it goal of 2% inflation, and the yen will start appreciating, just as investors have been predicting for 21 years.  In that case, interest rates in Japan may stay close to zero.

It’s entirely up to the BOJ which road they prefer to take.  A few months ago, many people thought they had given up.  Today that’s much less clear. The higher global interest rates following Trump’s election, combined with the BOJ policy of pegging the 10-year bond yield at zero, has caused the yen to plunge in value.  PPP is elastic, but not infinitely elastic.  The yen can’t stay here indefinitely without generating serious inflation.  Otherwise at some point a Lexus 430 would be as cheap as a candy bar.

My instincts tell me that this weird discrepancy between market predictions and actual outcomes can’t go on much longer.  Within the next decade it will be clear whether Japan is seriously committed to a 2% inflation target.  At that point, either Japanese interest rates will rise sharply (success), or the yen will appreciate sharply (failure).

PS.  At Econlog, I have a post on Nick Rowe’s reply to John Cochrane, which might be seen as loosely relating to this post.

Since the election, there’s been a lot of speculation that we are transitioning to a more inflationary environment.  That’s certainly possible, but I’d encourage everyone to take a deep breath.  There are three arguments I’ve seen for this claim, and two are extremely weak, while the third is mixed. Let me start with the strongest of the three, rising TIPS spreads.

As a believe in the EMH, I am not going to discount the importance of TIPS spreads, I’ve cited them in the past.  Rather, I’d like to put that evidence in perspective with a few observations:

1.  As of today, 5 and 10 year T-bond yields are up 50 and 54 basis points from a month ago.  That’s pretty significant.  But that’s mostly real rates, which are up 32 and 33 basis points.  That means TIPS spreads are up 18 to 21 basis points.  That’s not trivial, but it’s also not a dramatic game changer.  We’ve seen similar moves at times over the past 5 years, and not much happened.

2.  In addition, the level of inflation expectations remains well under 2%, especially when you subtract 30 basis points to reflect the fact that PCE inflation (the Fed’s target) runs about that much below CPI inflation (reflected in TIPS.)  This is important, because TIPS spreads (as we’ll see) are basically the ONLY evidence we have for the inflation story.  And even they are not predicting that the Fed will abandon its 2% inflation target (or ceiling, as some of you would claim.)

3.  While I often cite TIPS spreads, I’ve also acknowledged in the past that experts believe these spreads are somewhat distorted by shifts in risk premia. They aren’t perfect.  The Cleveland Fed, among others, attempts to come up with adjusted spreads to better reflect true inflation expectations.  Of course these estimates are model based, and hence are not perfect either.  Please send me any recent ones you come across.

Update:  JP Koning directed me to the Cleveland Fed.  Their model adjusts TIPS spreads to account for risk premia.  Yesterday they updated their 10-year inflation expectations estiamtes to 1.75%.  Last month it was 1.69%, and two months ago it was 1.72%.

4.  With some uncertainty about the accuracy of small moves in the TIPS spreads, where else can we look for inflation signals?  Well, the big story since the election has been the dramatic appreciation of the US dollar.  If we are to believe that Trump plans to debase the dollar through higher inflation, would you expect the forex value of the dollar to be surging higher on that information?  That’s not the macroeconomics I studied in school.  Indeed doesn’t the recent upswing in the dollar suggest we might get a bit lower inflation, as import prices drop?

5.  In contrast, there is an alternative explanation for these events.  Maybe the markets expect a dose of supply-side Reaganomics, and this is driving up expected RGDP growth (modestly to be sure, as rates are still low in absolute terms) and also driving up real bond yields and the value of the dollar.  That makes more sense than the inflation story, although I’m also willing to accept a mixed claim of “0.3% more trend RGDP growth and 0.2% more inflation” as being consistent with the various markets.

The other two arguments cited for higher inflation are especially weak.  One claim is that fiscal stimulus will drive up inflation.  But Yellen recently shot that down—the Fed fully intends to do monetary offset, and is recommending that Trump not do fiscal stimulus.  I have a post on that at Econlog.  (BTW, people frustrated with my Trump derangement over here should keep in mind that I always try to put my most important posts at Econlog.)

The other reason cited is that Trump might pack the Fed with compliant pro-growth, low interest rates doves like Arthur Burns.  But there are many problems with that claim.  Trump would not be able to get a change in the Fed’s official mandate through the Senate.  It would be highly controversial, and there are more than enough GOP mavericks and inflation hawks in the Senate to stop it.  Ditto for a choice of an obvious lackey for chair of the Fed.  He needs to put up a respectable name.  The press has discussed two groups of possible Fed appointments.  One is traditional conservatives like John Taylor and Martin Feldstein.  And the other group is more heterodox thinkers like David Malpass and Judy Shelton.  Neither group includes a single person who can be described as a “dove”.  Does anyone seriously think that John Taylor would switch the Fed to a 4% inflation target just to please Trump?

For better or worse we are locked into a world of low inflation.  Get used to it, it’s not going away.  And that means that artificial attempts to generate higher wages will do nothing but slow growth and reduce employment.

The TIPS spreads are a useful indicator of inflation expectations.  But they are not perfect.  The spread can be distorted by lots of factors, including changes in the risk premium and sudden swings in commodity prices (the TIPS adjustment occurs with a lag, so actual changes in commodity prices show up as expected changes in the CPI.)

Today, the 5-year TIPS spread is 1.77%.  Because it is based on the CPI, it corresponds to roughly 1.5% inflation on the PCE, which is the inflation rate that the Fed actually targets (at 2%.)

So if you believe TIPS spreads accurately measure inflation expectations, you are forced to believe that investors currently expect inflation to fall well below the Fed’s target over the next 5 years.

Over the past 12 months the PCE inflation rate has run at 1.37%, so it’s likely that investors expect a pick-up in inflation over the next 5 years.  But that was probably true before the election as well.  The core PCE is running at 1.7%, and most experts believe the core is a better indicator of future inflation, as it’s not effected by transitory swings in commodity prices.  It’s not that food and energy “don’t matter”, of course they matter a lot for consumer living standards, the point is that their relative prices are roughly a random walk, and hence the core is a better tool for forecasting inflation.

To summarize, the recent headlines about “inflation coming because of Trump” are only half true.  Yes, the TIPS spread has widened since the election, and I think it’s very possible that the increase was in part caused by the election.  That suggests that monetary offset is not perfect, not 100%.  On the other hand, in absolute terms the magnitudes are still quite low.  I still think we are looking at a 2% inflation economy, or slightly below, as far as the eye can see.  If it has increased a bit, we don’t know why.  Is it fiscal stimulus, or the expectation that Trump will appoint another Arthur Burns in 2018, or both?  I simply don’t know.  TIPS spreads often move around for reasons that are poorly understood.

FWIW, I’ve argued for years that 1.8% inflation is the new normal, not because the Fed wants it, rather because the policy that the Fed thinks will give them 2% inflation will probably actually give them about 1.8%, on average. Two percent during good times and 1% to 1.5% during bad times.  The Fed always tends to assume good times ahead. The recent moves in TIPS spreads are potentially important, but I’d need more evidence to move me off my 1.8% forecast.

PS. If you use 10-year TIPS, the spread is about 15 basis points higher, still pointing to sub-2% inflation going forward.

PPS.  As always, a NGDP futures market would add useful information.

We are long past the days of “fat cats”, when rich people could afford to eat more food than poor people.  And I’d argue that this is increasingly true almost everywhere you look.  When I was young, a Cadillac Eldorado was a vastly different car from a VW Beetle or Datsun.  Especially if cruising down the highway at 80 mph.  Today Datsun is called Nissan (one of the stupidest name changes in US history).  And while an Infiniti is a bit more luxurious than a Nissan, and the BMW handles somewhat better, I no longer think the experience of driving the Nissan is much different from a typical luxury car.  Even the size is similar.  Here’s the interior of their economy model (Sentra):

I went to Zillow, and randomly pulled off an ad for a 2800 sq foot condo in Chelsea—this one priced at $11 million.  And here’s a random 2600 sq. foot condo in Oklahoma City, priced at $260,000.  The NYC unit is more tastefully designed by NYC standards, but the OKC unit is more luxurious by OKC standards. In the Chelsea unit, you might want to have a $4000 midcentury-modern Poäng chair designed by Alvar Aalto:

In the OKC home you could install the Ikea version of the chair (shown above) for $79, down from a (inflation-adjusted price of) $350 in 1990.  How much utility does one get from the $4000 chair?  How much from the $79 chair?  It’s depends how you think about it–it’s the same chair.

Over at Econlog, I recently did a post about our post-stuff economy.  I grew up in the “stuff economy”, and I don’t think I’ll ever adapt to this new one.  But I suppose the millennials are right, it’s stupid to accumulate lots of stuff, for all the reasons that philosophers have emphasized down through the ages.  The upshot of all this is that the concept of “economic inequality” will become increasingly amorphous.  It won’t disappear by any means, indeed it might get “worse” in some sense.  But it will be harder to measure.  As an analogy, both cancer patients and hypochondriacs feel lots of pain. In both cases, the pain is “all in their heads”. That’s where you feel pain.  And that’s also where you register utility. What’s new is that it’s increasingly difficult to connect utility with physical objects (tumors in my medical analogy). (By the standards of peasant life in the Middle Ages, we are all a bunch of hypochondriacs—every one of us.) This has implications for everything from measuring the “Great Stagnation” to adjusting Social Security for “cost of living” (what does that even mean?) increases.

PS.  OK, maybe it’s not all in your head. I can’t really deny that this guy is better off than I am.  I’m jealous:

PPS.  Did Donald leave a window open?  Look at Melania’s dress.

PPPS.  Seriously, this is more my style.

PPPPS.  Off topic.  The rich plan to vote Democratic this time.