Friday, November 25, 2005

About Japanese Price Deflation

BBC Business News curiously reported that price deflation in Japan ended in October. Yet if you look deeper into the story you see that this refered to the Japanese version of "core inflation", which excludes only fresh food, but not non-fresh food or energy. Looking at the all-items index, price deflation in fact accelerated to -0.7%. While the deflation scare mongers thinks this is very bad, for the Japanese this means that their purchasing power is increasing as this is driven by increased supply of goods and not monetary deflation.

Interestingly, despite the fact that the inflation rate is exactly 5%:points lower in Japan than in the U.S. (which has 4.3% inflation), the yen have fallen dramatically (more than 15% ) against the U.S. dollar. This is clearly driven by the higher nominal interest rates in the U.S. But this capital flow is clearly irrational since real interest rates is higher in Japan. The real yield on 10-year bonds is 2% in Japan and nearly zero in the U.S. Combined with the accumulated fall in the yen's real exchange rate which makes the yen look highly undervalued, this means that Japanese bonds actually look more attractive than its U.S. counterparts, despite the lower nominal yields.


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