Deflation: Will America and Europe Follow Japan?

- "Investors are asking whether America and Europe will follow Japan into deflation. We think not. Japan fell into secular deflation because of a unique combination of structural factors. These factors are (a) high central bank independence with low accountability, (b) advanced aging of the population, (c) an electoral system that strongly over-represents the interests of older voters, and (d) a current account surplus that dulls the need for structural reforms."
- "Japan will likely remain in deflation, because none of the structural factors is likely to change soon."
- "The US is unlikely to fall into deflation. The Federal Reserve is more accountable and transparent than the Bank of Japan. The US is young; the electoral system does not over-represent older voters; the current deficit increases pressure for structural reform."
- "Europe is less likely than Japan but more likely than the US to fall into deflation. This is because Europe lies between Japan and the US on the four factors."
- "The best investment strategy is to seek yield and monetary assets in Japan, and seek beta and real assets in the US. Europe falls between the two. Inflation linked bonds are attractive. They provide protection in high inflation countries and high real rates in low inflation countries."
- Risk Scenario - Global Inflation: "In the risk scenario, where common global factors overcome regional differences, all developed economies are likely to tilt toward inflation. Nominal assets in all countries would likely underperform, and real assets outperform. Linkers would be attractive in most countries."

Morgan Stanley Global Economics 20100906

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