How the Japanese learnt to live with deflation, and enjoy it
In June 2011, then-BOJ governor Masaaki Shirakawa faced extreme pressure to double the monetary base, a step Kuroda took just days after replacing him in March. When Shirakawa, a University of Chicago-trained economist, was asked why he'd refused to budge, he offered a surprising excuse: Japan's ageing population, whose fixed incomes would be eaten away by rising prices. Politicians thought the rationale was a cop-out. Shinzo Abe's first act as prime minister was to dump Shirakawa.
Turns out, Shirakawa was on to something. In a new paper, Shock from Graying: Is the Demographic Shift Weakening Monetary Policy Effectiveness?, International Monetary Fund researcher Patrick Imam offers convincing evidence that ageing societies in Japan, Germany and, to some extent, the US can no longer be manipulated so easily by central bank policies.
Why? Changes in official interest rates are about influencing long-term expectations and short-term behaviour. Cutting rates is meant to make buying a new house, opening a business or betting on stocks more attractive today than next year. But such activity is disproportionately conducted by the young. That's Japan's problem. Today, one in four Japanese is older than 65; by 2060, that group will swell to more than 40 per cent of the population.
Even that isn't the whole story. Along with ugly demographics, Kuroda faces a Japanese public that has learned not only to live with deflation but also to enjoy it.
By 1990, asset prices weren't the only things that had veered into bubble territory in Japan. Arguably, the entire economy had. As the 1970s gave way to the heady 1980s, costs rose throughout the economy: food, transportation, service fees, power, telecoms, education, entertainment, apparel, you name it.
The story of Japan these past 20 years, from the government to banks to companies, has involved keeping consumer prices steady. Deflation has acted like a stealth tax cut for households and restored some sobriety to costs.
When economist Kosuke Motani made this argument in his 2010 book, The Real Face of Deflation, it fell with a thud in Nagatacho, Tokyo's Parliament precinct. Motani thinks Japan is experiencing "non-monetary deflation" on account of a national cost structure that overshot to the upside decades ago, a greying population that favours falling prices over rising ones, and a political system that doesn't understand deflation is a symptom of Japan's malaise, not the cause.
The theory among neoclassical economists that quantitative easing can overcome deflation, Motani argues, is "just like a religion". (He could as easily have said "cult".) As odd as it sounds, Japan's deflation has been as much a choice as a punishment. In order to avoid big, destabilising reforms, the government has amassed mountains of debt. Deflation, which lowers nominal bond yields, makes that burden easier to service.
This is the paradox facing Abe and Kuroda. Until now, the focus has been on how bond traders will react as a nation whose debt is approaching 250 per cent of GDP, and which enjoys sub-1 per cent 10-year bond yields, begins to produce sustained inflation. Equally important is how the nation's 126 million people, many elderly, cope.
"In Japan, all players have adapted to a deflationary environment: Households are used to increasing living standards without expecting higher wages, companies live from cost-cutting without fighting for bigger markets, the government needs low interest rates for most of its finance," says Martin Schulz, a former BoJ researcher and now senior economist at Fujitsu Research Institute. "Turning all this around will not be easy."
Frequently Asked Questions about this Article…
Japan's deflation refers to long-running steady or falling consumer prices. Over the past two decades households, businesses and the government have adapted: consumers have seen a kind of 'stealth' tax cut as costs stayed low, companies have focused on cost-cutting rather than chasing bigger markets, and the government has benefited from lower nominal borrowing costs. That combination helps explain why many Japanese have learned to live with—and in some ways prefer—lower prices.
Researchers (including an IMF paper cited in the article) argue that monetary policy works by changing expectations and short-term behaviour—like encouraging young people to buy homes, start businesses or invest in stocks. Japan already has a large older population (about one in four people over 65 today, rising to more than 40% by 2060), and older people are less responsive to those incentives. That demographic shift reduces how much cuts in official rates or quantitative easing can stimulate the economy.
Some economists cited in the article say QE assumes monetary tools can change expectations and spending choices—especially among the young. But Japan may be experiencing 'non-monetary deflation' driven by an oversized national cost structure, a greying population that prefers falling prices, and political constraints that avoid big structural reforms. Because of those non-monetary forces, QE alone may have limited power to restore sustained inflation.
If Japan moves from deflation to sustained inflation, bond traders will pay close attention because the country carries very large government debt (the article notes debt approaching 250% of GDP) while enjoying sub-1% 10-year bond yields. A shift to higher inflation could push yields up and change how Japan finances that debt, with important consequences for investors in Japanese government bonds and global fixed income markets.
Households have learned to raise living standards without expecting higher wages, while companies have focused on cutting costs rather than aggressively expanding markets. For everyday investors, that adaptation signals a long-run environment of subdued domestic demand and pressure on corporate margins, which can affect growth expectations, profit outlooks and returns from domestic investments.
Yes. The article highlights an argument that deflation reduces nominal bond yields, making it easier for a government with large debt to service obligations. Some commentators suggest Japan has tolerated or even relied on deflation as part of a broader strategy to avoid painful fiscal or structural reforms while keeping borrowing costs low.
Investors should watch for sustained inflation rather than temporary price spikes, significant rises in 10-year bond yields (Japan currently has sub-1% 10-year yields), clear shifts in consumer and corporate behaviour, and any major political or structural reforms that change the cost structure. How bond markets react to such changes will be especially informative.
Kuroda faces a complex mix of factors: a public and economy that have adapted to deflation, an ageing population less responsive to rate cuts, political constraints, and the legacy of earlier policy debates (including his predecessor Masaaki Shirakawa's reluctance to expand the monetary base). Together these make changing inflation expectations and behaviour difficult, a point underscored by former BoJ researcher Martin Schulz who says turning the situation around 'will not be easy.'
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