Morgan Stanley IM: Has Japan Finally Exited Deflation?

In the last 30 years the Japanese economy accomplished many firsts: it was the first post-war developed economy to experience sustained deflation, the first central bank to cut interest rates to zero and then negative territory, the first OECD country to recapitalize its banking system since the 1930s, the first government bond to yield less than 0%, and the first central bank to peg yields since 1951, when the Treasury-Federal Reserve Accord ended the 1940s-1950s U.S. interest rate peg.

Most of these firsts were the result of a massive deleveraging of the banking, real estate and corporate sectors since the peak of the Japanese bubble in 1989. This process has been labeled a balance sheet recession which lasted multiple economic cycles since 1989. Japanese consumer prices deflated a cumulative 5%, at an average annual pace of -0.4% over 14 years from 1998 to 2013. This sustained deflation persisted despite multiple attempts by monetary authorities at unconventional policies. However, inflation appears to have recently hit an inflection point with the highest headline (and core) inflation rates in thirty years. Investors are now left wondering whether this bout of inflation will prove transitory or persistent. In this paper, we assess whether Japan may be exiting deflation for good and the implications for monetary policy and Japanese assets.

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