Central banks, inflation, inflation expectations, currency wars and the Japanese experiment
This is going to be a relatively short note focused on what is going on in Japan because of the news that Japan has ramped up its program of quantitative easing to new heights. Coming on the heels of the US Federal Reserve’s announcement that it would stop expanding its balance sheet with large scale asset purchases, the Bank of Japan’s announcement was music to the ears of Japanese equities investors. And shares in Japan promptly rose 4.8% on the news. The larger question, however, is whether QE is effective either at shaping future inflation or inflation expectations or at increasing nominal and real GDP. The evidence is equivocal. And so Japan presents a unique opportunity to see the limits of monetary policy tested.
Before I go into the Japanese experiment, I want to note that we got two bits of inflation news today. In the US, the Wall Street Journal noted that inflation has undershot the Fed’s 2% target for a 29th straight month with the release of data on personal consumption expenditures. And the PCE was weak even so, with the real number advancing a mere 1.8%. Nominal spending growth then is extremely weak.
I also noted this morning that market-based measures of inflation like the 5-year TIPS breakeven have been declining throughout the QE3 program:
Chart of 5-Year Breakeven Inflation Rate during QE3 is mostly down. It has dropped nearly 1% pic.twitter.com/L5iRld49i2
— Edward Harrison (@edwardnh) October 31, 2014
In Europe, inflation picked up to 0.4% from 0.3% in the Eurozone, which is positive news if you want to call it that, given the worry about deflation in the Eurozone.
So, despite huge efforts by American and European monetary authorities, inflation and inflation expectations are falling. One might be tempted to say the problem is the central bank’s resolve. If the CB were more resolute in expanding its balance sheet or moved to a nominal GDP target then expectations would adjust accordingly. But this is where the Japanese experiment comes into the picture. The Japanese were the first to deal with a large private debt overhang,deflation, zero rates and QE during this secular credit cycle. And so they offer an insight in what to expect as well as what to do or not to do to deal with the problem.
With the consumption tax increase causing household spending to fall for six months on the trot and with oil prices having plummeted, the Bank of Japan must be panicked because inflation and inflation expectations are now receding, even in Japan, where we have been told the battle against deflation had been won by monetary stimulus. It hasn’t. And so the BoJ is now buying more assets.
the BOJ’s board voted 5-4 to accelerate purchases of Japanese government bonds so that its holdings increase at an annual pace of 80 trillion yen ($723.4 billion), up by 30 trillion yen.
The central bank also said it would triple its purchases of exchange-traded funds (ETFs) and real-estate investment trusts (REITs) and buy longer-dated debt, sending Tokyo shares soaring and prompting a sharp sell-off in the yen.
“Japan’s economy continues to recover moderately as a trend and it’s expected to keep growing above its potential,” the central bank said. “But weak domestic demand after the sales tax hike and sharp falls in oil prices are weighing on prices.”
The FT’s Izabella Kaminska also reminds us that the public pension scheme in Japan will now be filling inthe holes here and rebalancing its buying away from bonds and toward equities and foreign assets. She quotes Soc Gen’s Kit Juckes saying, rather importantly:
The BOJ is effectively plugging the hole left by the reduction in the GPIF’s JGB allocation. The GPIF is instead increasing its domestic equity holdings from 12% to 25% of the fund, which will inject ¥16.5trn ($150bn) into the Japanese stock market. The GPIF will also increase holdings of foreign equities and bonds to 40% from 23%, so sending ¥21.5trn ($195bn) overseas. That is negative for the yen.
The Japanese Yen is now at a 7-year low against the dollar as a result.
Let me cut to the chase here. These are extreme measures and extreme levels of central bank intervention into the economy to get it to respond. The BoJ has implicitly set a nominal GDP target by setting a 2% medium-term target on inflation with the residual being real GDP. So clearly the BoJ wants real GDP to increase. And thus this is about as close as you are going to get to the vaunted NGDP target monetarists bang on about. Yet, we are seeing the BoJ have to extend its medium-term time frame to three years instead of two because it will not be able to lift inflation to the 2% level quickly enough, even with the draconian policies it has implemented.
That tells you something.
What I am seeing is failure. Central banks are trying as hard as they can to get their economies lifted up. And yet they seem as far from their goal of higher real growth and higher nominal GDP as ever. One reason that many fail to credit is politics. The fact of the matter is that aggressive fiscal and monetary policy is going to always be seen as a last resort and something to be avoided. There’s no getting around that. I know Paul Krugman makes it seem like we need to and can get over that hurdle in his latest column, but I would say Japan is proof of how difficult it is. The consumption tax increase and the 5-4 vote narrowly in favour of the latest QE from the Bank of Japan are but two examples of political opposition to more stimulus at the expense of the currency and the public sector balance sheet. In Europe and the US, the same forces are at play to differing degrees and this will always be the case.
In any event, we will have to wait longer to see how this experiment is playing out. It is getting the Yen down and stocks up. They’re at a 7-year high. But right now, I would say the Japanese experiment is failing.