Monetary policy provides no answer for a chronic deficiency of aggregate demand: Yet another lesson from Japan…

From Stephen Roach:

Yet another in a long string of negative inflation surprises is at hand. In the United States, the so-called core CPI (consumer price index) – which excludes food and energy – has headed down just when it was supposed to be going up. Over the three months ending in May, the core CPI was basically unchanged, holding, at just 1.7% above its year-earlier level. For a US economy that is widely presumed to be nearing the hallowed ground of full employment, this comes as a rude awakening – particularly for the Federal Reserve, which has pulled out all the stops to get inflation back to its 2% target.

Halfway around the world, a similar story continues to play out in Japan. But, for the deflation-prone Japanese economy, it’s a much tougher story.

Through April, Japan’s core CPI was basically flat relative to its year-earlier level, with a similar outcome evident in May for the Tokyo metropolitan area. For the Bank of Japan (BoJ), which committed an unprecedented arsenal of unconventional policy weapons to arrest a 19-year stretch of 16.5% deflation lasting from 1994 to 2013, this is more than just a rude awakening. It is an embarrassment bordering on defeat.

This despite years of policy activism:

In a world of hyper-globalization – barring a protectionist relapse led by the America Firsters – treatment needs to be focused on the demand side of the equation. The most important lesson from the 1930s, as well as from the modern-day Japanese experience, is that monetary policy provides no answer for a chronic deficiency of aggregate demand. Addressing it is a task primarily for fiscal authorities. The idea that central banks should consider making a new promise to raise their inflation targets is hardly credible.

In the meantime, Fed Chair Janet Yellen is right (finally) to push the Fed to normalize policy, putting an end to a failed experiment that has long outlived its usefulness. The danger all along has been that open-ended unconventional monetary easing would fail to achieve traction in the real economy, and would inject excess liquidity into US and global financial markets that could lead to asset bubbles, reckless risk taking, and the next crisis. Moreover, because unconventional easing was a strategy designed for an emergency that no longer exists, it leaves the Fed with no ammunition to fight the inevitable next downturn and crisis.

We ignore history at great peril. The latest disappointment for inflation-targeting central banks is really not a surprise after all. The same is true of the related drop in long-term interest rates. There is much to be gained by studying carefully the lessons of Japan.

Earlier we said central banks did not do enough to prevent great depression. Now we say that central banks did a bit too much in the Great recession..

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