The ECB should give Bob Hetzel a call

The ECB is very eager to stress that the monetary transmission mechanism in some way is broken and that the policy measures needed is not quantitative easing, but measures to repair the monetary transmission mechanism.

In regard to ECB’s position I find this quote from a excellent paper – What Is a Central Bank? – by Bob Hetzel very interesting:

For example, in Japan, the argument is common that the bad debts of banks have broken the monetary transmission mechanism. The central bank can acquire assets to increase the reserves of commercial banks, but the weak capital position of banks limits their willingness to engage in additional lending. As in the real bills world, the marketplace controls the ability of the central bank to create independent changes in money that change prices.

According to the quantity theory as opposed to the real bills view, a central bank exercises its control over the public’s nominal expenditure through money (monetary base) creation. That control does not derive from the central bank’s influence over financial intermediation. A commercial bank acquires assets by making its liabilities attractive to individuals who forego consumption to hold them. In contrast, a central bank acquires assets through the ability to impose a tax (seigniorage) that comes from money creation. It imposes the tax directly on holders of cash and indirectly on holders of bank deposits to the extent that banks hold reserves against deposits.

Bob wrote the paper while he was a visiting scholar at the Bank of Japan in 2003.

It is striking how the present position of the ECB is similar to the BoJ’s position at the time Bob spend time there. Maybe the ECB should invite Bob to pay a visit?

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See also Bob’s paper Japanese Monetary Policy and Deflation.

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Let me say it again – The Kuroda recovery will be about domestic demand and not about exports

This morning we got strong GDP numbers from Japan for Q1. The numbers show that it is primarily domestic demand – private consumption and investment – rather than exports, which drive growth.

This is from Bloomberg:

Japan’s economy grew at the fastest pace since 2011 in the first quarter as companies stepped up investment and consumers splurged before the first sales-tax rise in 17 years last month.

Gross domestic product grew an annualized 5.9 percent from the previous quarter, the Cabinet Office said today in Tokyo, more than a 4.2 percent median forecast in a Bloomberg News survey of 32 economists. Consumer spending rose at the fastest pace since the quarter before the 1997 tax increase, while capital spending jumped the most since 2011.

…Consumer spending rose 2.1 percent from the previous quarter, the highest since a 2.2 percent increase in the first three months of 1997.

So it is domestic demand, while net exports are actually a drag on the economy (also from Bloomberg):

Exports rose 6 percent from the previous quarter and imports climbed 6.3 percent.

The yen’s slide since Abe came to power in December 2012 has inflated the value of imported energy as the nation’s nuclear reactors remain shuttered after the Fukushima disaster in March 2011.

The numbers fits very well with the story I told about the excepted “Kuroda recovery” (it is not Abenomics but monetary policy…) a year ago.

This is what I wrote in my blog post “The Kuroda recovery will be about domestic demand and not about exports” nearly exactly a year ago (May 10 2013):

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

…I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we seeing the yen weaken, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

the focus on the“competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

While I am happy to acknowledge that today’s numbers likely are influenced by a number of special factors – such as increased private consumption ahead of planned sales tax hikes and likely also some distortions of the investment numbers I think it is clear that I overall have been right that what we have seen in the Japanese economy over the past year is indeed a moderate recovery led by domestic demand .

The biggest worry: Inflation targeting and a negative supply shock

That said, I am also worried about the momentum of the recovery and I am particularly concerned about the unfortunate combination of the Bank of Japan’s focus on inflation targeting – rather than nominal GDP targeting – than a negative supply shock.

This is particularly the situation where we are both going to see a sales tax hike – which will increase headline inflation – and we are seeing a significant negative supply shock due to higher energy prices. Furthermore note that the Abe administration’s misguided push to increase wage growth – to a pace faster than productivity growth – effectively also is a negative supply shock to the extent the policy is “working”.

While the BoJ has said it will ignore such effects on headline inflation it is likely to nonetheless at least confuse the picture of the Japanese economy and might make some investors speculate that the BoJ might cut short monetary easing.

This might explain three factors that have been worrying me. First, of all while broad money supply in Japan clearly has accelerated we have not see a pick-up in money-velocity. Second, the Japanese stock market has generally been underperforming this year. Third, we are not really seeing the hoped pick-up in medium-term inflation expectations.

All this indicate that the BoJ are facing some credibility problems – consumers and investors seem to fear that the BoJ might end monetary easing prematurely.

To me there is only one way to fundamentally solve these credibility problems – the BoJ should introduce a NGDP level target of lets say 3-4%. That would significantly reduce the fear among investors and consumers that the BoJ might scale back monetary easing in response to tax hikes and negative supply shocks, while at the same time maintain price stability over the longer run (around 2% inflation over the medium-term assuming that potential real GDP growth is 1-2%).

PS Q1 2014 nominal GDP grew 3.1% y/y against the prior reading of 2.2% y/y.

PPS See also my previous post where I among other things discuss the problems of inflation targeting and supply shocks.

The Kuroda boom remains all about domestic demand

Remember when then Bank of Japan last year initiated its unprecedented program of monetary easing most commentators saw that as an attempt to wage currency war to boost Japanese exports? I instead stressed that the “export channel” was not likely to be what would drag Japan out of the deflationary trap. Rather I stressed the importance of domestic demand.

This is what I said in May last year:

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment are likely to significantly boost Japanese nominal GDP growth – and likely also real GDP growth in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we are seeing the yen weaken, Japanese stock markets rallying and inflation expectations rising at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first thing we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

Two things are happening at the moment in the Japan. One, the money base is increasing dramatically. Second and maybe more important money-velocity is picking up significantly.

Velocity is of course picking up because money demand in Japan is dropping as a consequence of households, companies and institutional investors expecting the value of the cash they are holding to decline as inflation is likely to pick up. The drop in the yen is a very good indicator of that.

And what do you do when you reduce the demand for money? Well, you spend it, you invest it. This is likely to be what will have happen in Japan in the coming months and quarters – private consumption growth will pick-up, business investments will go up, construction activity will accelerate.

…Hence, the Bank of Japan (and the rest of us) should celebrate the sharp drop in the yen as it is an indicator of a sharp increase in money-velocity and not because it is helping Japanese “competitiveness”.

Since then the Japanese economy has continued to recover  (much more strongly than any other of the major developed economies in the world) and it has to a very large extent been about domestic demand rather than exports.

And this morning we got the latest confirmation of a recovery driven by domestic demand. Just take a look at this story from the Dow Jones News Wire:

Japan’s domestic sales of new cars, trucks and buses climbed 18.7% from a year earlier in December for the fourth straight month, rising from a low basis of comparison a year earlier when demand was hurt after the end of the government incentives to buy fuel-efficient cars.

Sales totaled 254,464 vehicles in December, up from 214,429 in the same month last year, the Japan Automobile Dealers Association said Monday.

Toyota sales rose 11.8% to 102,566, with its Lexus luxury brand registering a 15.1% increase to 3,414. Nissan sold 31,420 vehicles, up a modest 1.0%. Honda’s sales doubled to 38,767 from 18,886 after the introduction of the redesigned Fit compact in September.

With the latest monthly figures counted, the nation’s domestic auto sales for the calendar year 2013 fell 3.8% to 3.26 million vehicles from 3.39 million in 2012, the association said.

Auto sales, as measured by vehicle registrations with the government, are monitored by economists since they are the first consumer spending numbers released each month.

So let me say it again – it’s domestic demand, stupid!

Kuroda’s masterful forward guidance

This is from cnbc.com:

Talk of further monetary stimulus from the Bank of Japan helped push the yen to a six-month low and lifted the Nikkei to a six-month high on Tuesday, and the move in Japanese assets may have further to run, analysts say.

Comments made by Bank of Japan (BOJ) governor Haruhiko Kuroda on Monday fueled speculation of further easing, after he told participants at a conference “we are ready to adjust monetary policy without hesitation if risks materialize.”

Is forward guidance important? Yes, it is tremendously important – particularly is you have little credibility about your monetary policy target. The Bank of Japan for 15 years failed to meet any monetary policy target, but since Haruhiko Kuroda became BoJ governor things have changed. His masterful forward guidance has significantly increased monetary policy credibility in Japan.

Few in the market place today can doubt that governor Kuroda is committed to meeting his 2% inflation target and that he will do whatever it takes to hit that target. Furthermore, when Kuroda says that he is “ready to adjust monetary policy without hesitation if risks materialize” he is effectively making the the Sumner Critique official policy.

Said in another way – governor Kuroda will adjust his asset purchases – if necessary – to offset any other shocks to aggregate demand (or rather money-velocity) for example in response to the planned increase in Japanese sales taxes.

As a consequence of Kuroda’s forward guidance market participants know that the BoJ will offset any effect on aggregate demand of the higher sales tax and as a consequence the expected (net) impact of the sales tax increase is zero. This of course is the Sumner Critique – an inflation targeting (or NGDP targeting) central bank will offset fiscal shocks to ensure that the fiscal multiplier is zero.

So what is happening is that market participants expect monetary easing in reaction to fiscal tightening – this is now lifting Japanese equity prices and weakening the yen. This will boost private consumption, investment and exports and thereby offset the impact on aggregate demand from the increase in sales taxes.

The Bank of Japan likely have to step up its monthly asset purchases to offset the impact of the higher sales taxes as the BoJ’s inflation target is still not fully credible. However, given Mr. Kuroda’s skillful forward guidance the BoJ will have to do a lot less in terms of an actually increase in asset purchases than otherwise would have been the case. That in my view demonstrates the importance of forward guidance.

My expectation certainly is that the plan sales tax increase in Japan will once again demonstrate that the fiscal multiplier is zero under credible inflation targeting (also that the Zero Lower Bound!) and there is in my view good reason to think that the Japanese economy will continue to recover in 2014 – to a large extent thanks to governor Kuroda’s skillful forward guidance and his commitment to hitting the BoJ’s inflation target.

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Related post: There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

“Whatever it takes to get deflation” (Stealing two graphs from Marcus Nunes)

Marcus Nunes has two extremely illustratative graphs in his latest blog post. Just take a look here:

 

 I don’t think any other comments are needed…

End the euro crisis now with a 10% M3 target

This is Michael Steen in the Financial Times:

Inflation in the eurozone dropped unexpectedly to an annual rate of 0.7 per cent in October, far below the European Central Bank’s target of close to but below 2 per cent, and significantly increasing the chances of an interest-rate cut.

The so-called “flash” estimate by Eurostat, the EU’s statistical office, showed that the rate at which prices rise had slowed further since September, when it was 1.1 per cent, which is roughly what economists had expected for October.

A sharp outright fall in energy costs, by 1.7 per cent, drove the slowdown in the harmonised indices of consumer prices, which the ECB targets, but “core inflation”, which strips out energy, food, alcohol and tobacco, also fell to 0.8 per cent from 1 per cent.

I must say I am not the least surprised by the fact that the euro zone is heading for deflation. This is what I told The Telegraph’s Ambrose Evans-Pritchard back in March:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

It is tragic, but what we are seeing now in Europe is exactly the same as we saw in Japan in the mid-1990s – a central bank that pursued extremely tight monetary policies, while it continued to maintain that monetary policy was indeed very easing. We all know the result of the Bank of Japan’s failed policies was 15 years of stagnation and deflation – and sharply rising public debt levels. The ECB unfortunately is copying exactly the policies of the (old) BoJ instead of learning the lesson from the new BoJ’s effective anti-deflationary policies.

As I have earlier argued the development in velocity and money supply growth in Europe today is very similar to what we saw in Japan around 1996-97. Not surprisingly the outcome is the same – extremely weak nominal GDP growth and deflationary tendencies. In fact the outcome is much worse. Unemployment in the euro zone just keep on rising – contrary to the situation in the US, where the Fed’s monetary easing over the past year has helped improve the labour market situation.

In fact the latest unemployment numbers for the euro zone published yesterday (Thursday) shows that unemployment in the euro zone has reached a record-high level of 12.2% in September and even worse youth unemployment is now 24.1%. It is hard not to conclude that the ECB is directly responsible for the millions of European being without a job. Yes, there are serious structural problems in Europe, but the sharp increase in unemployment levels in the euro zone since particularly since the ECB’s misguided rate hikes in 2011 is nearly totally the fault of the ECB’s extremely tight monetary policy stance.

We are heading for deflation

But lets get back to why deflation looks more and more likely in the euro. This is what I had to say about the matter back in March:

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y

<=>

(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, it is really that simple and the policy makers in the ECB should of course have realized this long ago.

End the euro crisis now with a 10% M3 target

There is only one way to avoid deflation in the euro zone and that is an aggressive monetary policy response in the form of a significant and permanent expansion of the euro zone money base within a clearly defined rule-based framework.

I would obviously prefer that the ECB implemented an clear NGDP level targeting rule, but less might do it – and a lot of other policy options would be preferable to the present mess.

The “easy” solution would be for the ECB to re-instate its former two-pillar monetary policy – a money supply (M3) growth target and an inflation target. Therefore, I suggest that the ECB imitiately issues the following statement (I have suggested it before):

“Effective today the ECB will start to undertake monetary operations to ensure that euro zone M3 growth will average 10% every year until the euro zone output gap has been closed. The ECB will allow inflation to temporarily overshoot the normal 2% inflation. The ECB has decided to undertake these measures as a failure to do so would seriously threatens price stability in the euro zone – given the present growth rate of M3 deflation is a substantial risk – and to ensure financial and economic stability in Europe. A failure to fight the deflationary risks would endanger the survival of the euro.

The ECB will from now on every month announce an operational target for the purchase of a GDP weighted basket of euro zone 2-year government bonds. The purpose of the operations will not be to support any single euro zone government, but to ensure a M3 growth rate that is comparable with long-term price stability. The present growth rate of M3 is deflationary and it is therefore of the highest importance that M3 growth is increased significantly until the deflationary risks have been substantially reduced.

The announced measures are completely within the ECB’s mandate and obligations to ensure price stability and financial stability in the euro zone as spelled out in the Maastricht Treaty.”

That would end the euro crisis, while also ensuring inflation around 2% in the medium-term. There would be no bailing out or odd credit policies. Only a clear and rule based policy to ensure nominal stability. How hard can it be?

Abe should repeat Roosevelt’s successes, but not his mistakes

There is more good news from Japan today as new data shows that core inflation rose to 0.8% y/y in August and I think it is now pretty clear that the Bank of Japan is succeeding in defeating 15 years’ of deflation. Good job Mr. Kuroda!

BoJ chief Kuroda has done exactly done what Ben Bernanke called for back in 1999:

Franklin D. Roosevelt was elected President of the United States in 1932 with the mandate to get the country out of the Depression. In the end, the most effective actions he took were the same that Japan needs to take—- namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment—-in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done. Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening?

To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

So far so good and there is no doubt that governor Kuroda has exactly shown Rooseveltian resolve. However, while Roosevelt undoubtedly was right pushing for monetary easing to end deflation in 1932 he also made the crucial mistake of trying to increase wages.

One can say that Roosevelt succeed on the demand side of the economy, but failed miserably on the supply side of the economy. First, Roosevelt push through the catastrophic National Industrial Recovery Act (NIRA) with effectively was an attempt to create a cartel-like labour market structure in the US. After having done a lot of damage NIRA was ruled unconstitutional by the US supreme court in 1935. That helped the US recovery to get underway again, but the Roosevelt administration continued to push for increasing labour unions’ powers – for example with the Wagner Act from 1935.

While it is commonly accepted that US monetary policy was prematurely tightened in 1937 and that sent the US economy into the recession in the depression in 1937 it less well-recognized that the Roosevelt administration’s militant efforts to increase the unions’ powers led to a sharp increase in labour market conflicts in 1936-37. That in my view was nearly as important for the downturn i the US economy in 1937 as the premature monetary tightening.

Prime Minister Abe is repeating Roosevelt’s mistakes   

The “logic” behind Roosevelt’s push for higher was that if inflation was increased then that would reduce real wages, which would cut consumption growth. This is obviously the most naive form of krypto-keynesianism, but it was unfortunately a widespread view within the Roosevelt administration, which led Roosevelt to push for policies, which seriously prolonged the Great Depression in the US.

It unfortunately looks like Prime Minister Abe in Japan is now pushing for exactly the same failed wage policies as Roosevelt did during the Great Depression. That could seriously undermine the success of Abenomics.

This is from Bloomberg today:

“Abe last week began meetings with business and trade union leaders to press his case for wage increases, key to the success of his effort to spur growth under his economic policies dubbed Abenomics.”

This is exactly what Roosevelt tried to do – and unfortunately succeed doing. His policies was a massive negative supply shock to the US economy, which pushed wages up relatively what would have happened with out policies such as NIRA. The result was to prolong the depression and I am fearful that if Prime Minister Abe will be as successful in pushing for higher wage growth in Japan it will undermine the positive effective of Mr. Kuroda’s monetary easing – inflation will rise, but economic growth will stagnate.

What Prime Minister Abe is trying to do can be illustrated in a simple AS-AD framework.

Abe wage shock

Mr. Kuroda’s monetary easing is clearly increasing aggregate demand in the Japanese economy pushing the AD curve to the right (from A to B). The result is higher inflation and higher real GDP growth. This is what we are now clearly seeing.

However, Prime Minister Abe’s attempt of increasing wages can only be seen as negative supply shock, which if successful will push the AS curve to the left (from B to C). There is no doubt that the join efforts of Mr. Kuroda and Mr. Abe are pushing up inflation. However, the net result on real GDP growth and employment is uncertain.

I am hopeful that Mr. Abe is not really serious about pushing up wages – other than what is the natural and desirable consequence of higher demand growth – and I hope that he will instead push much harder to implement his “third arrow”, which of course is structural reforms.

Said, in another way Mr. Abe should try to push the AS curve to the right instead of to the left – then Abenomics will not repeat the failures of the New Deal.

There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

It is now very clear that what Milton Friedman advocated the Bank of Japan should do back in the mid-1990s – to expand the money base to get Japan out of deflation – is in fact working. Nominal spending growth is accelerating and with it deflation has come to an end and real GDP growth is fairly robust.

However, some have been arguing the success of Abenomics will be short-lived and that the planned increases in the Japanese sales tax might send Japan back into recession. In other words Japan is facing a fiscal cliff.

In this post I will argue that like in the case of the 2013-US fiscal cliff the fears of the negative impact of fiscal consolidation is overblown and that the risk of recession in Japan is very small if the Bank of Japan keeps doing its job and try to get inflation expectations back to 2%. It is yet another illustration of the Sumner Critique.

All we need is the AS-AD framework

I think it is pretty easy to illustrate the impact of a sales tax increase in a world with a central bank with a credible inflation target within a simple AS-AD framework.

We start out with a Cowen-Tabarrok style AS-AD framework. We use growth rates rather levels and aggregate demand curve is given by the equation of exchange (mv=py).

The graph below is our starting point.

AS AD

We have assumed that inflation in the starting point already is at 2%. This obviously is not correct, but it does not fundamentally change the analysis of the “fiscal shock”.

Japan’s sales tax will be raised to 8 percent from 5 percent in April and to 10 percent in October 2015, but here we just assume it is one fiscal shock. Again that is not important for the conclusions.

A negative fiscal shock in a Cowen-Tabarrok style AS-AD framework is basically a negative shock to money velocity (v), which will push the AD curve to the left as nominal spending drops.

However, as it is clear from the graph this will initially push inflation below the Bank of Japan’s 2% inflation target. We are here ignoring headline inflation will increase, but we are here focusing on core inflation as is the BoJ. Core inflation will drop as illustrated in the graph below.

inflation target BoJ ASAD

If the Bank of Japan is serious about its inflation target it will respond to any demand-driven drop in inflation by counteracting that with an one-to-one increase in the money base to bring back inflation to 2%.

The consequence of BoJ’s 2% inflation is hence that there will be full monetary offset of the negative fiscal shock and as a consequence inflation should broadly speaking remain unchanged at 2% and real GDP growth will be unaffected. Hence, under a credible inflation target the fiscal multiplier is zero. As in the case of the US there will be no fiscal cliff. There will be fiscal consolidation but not a negative impact on growth.

This of course does not mean that the fiscal shock will not have any impact on the Japanese economy or markets. It very likely will. It is for example clear that if the markets expect the BoJ to step up asset purchases (increase money base growth) in response to fiscal tightening then that would likely weaken the yen further. Something Japanese exporters likely will be happy about. As a consequence the sales tax hikes will likely change the composition of growth in Japan.

Finally, it should be noted that everybody in Japan is fully aware of the miserable state of public finances and as a result it is hardly a surprise to Japanese households that the government sooner or later would have to do something to improve public finances. In fact the sales tax hike was announced long ago. Therefore, we should expect some Ricardian equivalence effects to come into play here – an increase net government saving is likely to reduce net private savings. So even with no monetary offset there is likely to be some Ricardian offset. That in my view, however, is significantly less important than the monetary policy offset.

How aggressive will the BoJ have to be to offset the fiscal shock?

A crucial question of course will be how much additional monetary easing is needed to offset the fiscal shock. Here the credibility of the BoJ’s inflation comes into play.

If the BoJ’s inflation target was 100% credible we could actually argue that the BoJ would not have to increase the money base at all. The Chuck Norris effect would take care of everything.

Hence, if everybody knows that the BoJ always will ensure that inflation (and inflation expectations) is at 2% then when a fiscal shock is announced the markets will realize that that means that the BoJ will ease monetary policy. Easier monetary policy will push up stock prices and weaken the yen. That will in itself stimulate aggregate demand. In fact stock prices will continue to rise and the yen will continue to weaken until the markets are “satisfied” that inflation expectations remain at 2%.

In fact this might exactly be what is happening. The yen has generally continued to weaken and the Japanese stock markets have been holding up quite well even through the latest round of turmoil – Fed tapering fears, Syria, Emerging Markets worries etc.

But obviously, the BoJ’s inflation target is not entirely credible and inflation expectations are still well-below 2% so my guess would be that the BoJ might have to step up quantitative easing, but it is certainly not given. In fact the Japanese recovery is showing no signs of slowing down and inflation – both headline and core – continues to inch up.

A golden opportunity for the BoJ to increase credibility

Hence, I am not really worried about the planned sales tax hikes. I don’t like taxes, but I don’t think a sales tax hike will kill the Japanese recovery. In fact I believe that the sales tax hikes are a golden opportunity for the Bank of Japan to once and for all to demonstrate that it is serious about its 2% inflation.

The easiest way to do that is basically to copy a quite interesting note from the Reserve Bank of New Zealand on “Fiscal and Monetary Coordination”. This is from the note:

“…the Reserve Bank, therefore, is required to respond to developments in the economy – including changes in fiscal policy – that have material implications for the achievement of the price stability target;”

And further it says:

“These… features mean that monetary and fiscal policy co-ordination occurs through the Reserve Bank taking fiscal policy into account as an element of the environment in which monetary policy operates. This approach is to be contrasted with approaches to co-ordination that involve joint determination of monetary policy by the monetary and fiscal policy agencies.”

And finally:

“While demand – and thus inflation – pressures may originate from a range of different sources, the task of monetary policy is to respond so as to maintain an overall level of demand consistent with keeping inflation in one to two years’ time within the target range. For example, if the government increases its net spending, all other things being equal, monetary policy needs to be tighter for a time, so as to slow growth of private demand and “make room” for the additional government spending.”

If the BoJ copied this note/statement then it basically would be an open-ended commitment to offset any fiscal shock to aggregate demand – and hence to inflation – whether positive or negative.

By telling the market this the Bank of Japan would do a lot to reduce the worries among some market participants that the BoJ might not be serious about ensuring that its 2% inflation target will be fulfilled even if fiscal policy is tightened.

So far BoJ governor Kuroda has done a good job in managing expectations and so far all indications are that his policies are working – deflation seems to have been defeated and growth is picking up.

If Kuroda keeps his commitment to the 2% inflation target and stick to his rule-based monetary policy and strengthens his communication policies further by stressing the relationship between monetary policy and fiscal policy – RBNZ style – then there is a good chance that the planed sales tax hikes will not be a fiscal cliff.

Mr. Kuroda’s vacation plans

This is from the Wall Street Journal blog Japan Real Time:

Bank of Japan Gov. Haruhiko Kuroda has set himself apart from his predecessors with his aggressive style of running the central bank, and it turns out his approach to preparing for summer vacation is a departure from the past too.

In an unusual move for a Japanese central bank governor, Mr. Kuroda on Monday talked a little about his summer holiday plans.

“To tell the truth, I’m planning to take time overseas for a summer holiday in mid-August,” Mr. Kuroda said in response to a question at an otherwise straightforward speech on monetary policy and the economy.

While taking a week off during the summer isn’t unusual for a BOJ governor or other senior officials, talking about it in front of an audience of nearly 1,400 is unusual.

Customarily, the BOJ keeps the governor’s holiday schedule secret, partly out of concern that announcing it could lead to unintended speculation in financial markets.

Moreover, the BOJ governor’s absence during Japan’s traditional August holiday season suggests the central bank doesn’t expect any major issues to arise during that period. Mr. Kuroda did indeed appear relaxed as he talked about the effects of his monetary easing program, saying the economy is on a “steady path toward escaping deflation.”

Good for him! This is how a central bank chief should be speaking, but it is in stark contrast to the “central banker as firefighter” attitude of many central bankers around the world.

If you think of yourself as a firefighter who permanently have to stand ready to fly in a save the world when crisis erupts you will never have time for vacation. In fact you would think that if you tell anybody that you go on vacation then the world will fall apart because you are not there to fight the fire.

However, it seems like Mr. Kuroda rightly do not see himself as a firefighter, but rather as a rule-following central banker. He has used his first time in office to spell out what Bank of Japan’s nominal target (2% inflation) and what instrument (money base expansion) he will to achieve this target.

As a result he could and should look relax and he should certainly take the luxury of a one-week vacation. In fact I would argue that he could easily book a month’s vacation if he was confident that Japanese public and the markets understood the BoJ’s target and its “reaction function”.  He wouldn’t have to do much – given the announced monetary base expansion goes on and the inflation target is well-defined he should leave the rest of the “implementation” of monetary policy to the market.

Imagine that his policy was 100% credible (it is not!) and a shock hits while he was on vacation. Lets for example imagine the the euro crisis flares up again and initially the demand for yen spikes. That would push down Japanese inflation expectations. However, under a 100% credible 2% inflation target if inflation expectations drops below the target investors will soon realize that that the BoJ will not allow inflation expectations to remain under 2% and as a result it will be profitable to put on trades that benefits from an easier monetary policy – higher stock prices, a weaker yen and a steeper yield curve. By doing this investors would automatically “implement” monetary easing and that will push inflation expectations back to 2% – whether or not Mr. Kuroda was on vacation or not.

Lack of credibility shortens Mr. Kuroda’s vacation

Unfortunately Mr. Kuroda’s inflation target is still not a 100% credible. In fact we are still very far from having a fully credible monetary policy target in Japan. Hence, market expectations of future Japanese inflation is still way below 2%. That is a pretty clear indication that investors are not fully convinced that Mr. Kuroda is on the way to beating deflation.

Therfore, more work is needed to establish monetary policy credibility in Japan. I have previously argued (see here and here) that Mr. Kuroda should be even more explicit on referring to market inflation expectations than he has been.

So maybe he should have added the following statement when he talked about his vacation plans:

“…So while inflation expectations have increased they are still far below our 2% inflation target on all relevant time horizons. We therefore stand ready if necessary to further step up the monthly increase in the money base. We will evaluate that need based on market expectations of future inflation.

We will particularly focus on market pricing of 2year/2year and 5year/5year break-even inflation expectations. We want investors to understand that we will ensure that market pricing fully reflects our inflation target. That means 2% inflation expectations on all relevant time horizons. No less, no more.

So when I am back from vacation in four weeks time I am sure the market will be pricing in 2% inflation. See you guys.”

The world needs central bankers who implement credible nominal targets and therefore are able to take long vacations rather than firefighting central bankers who are never on vacation. The fact that Mr. Kuroda happily talks about his vacation plans indicate that we indeed has seen a shift in monetary policy in Japan from firefighting to a (more) rule-based monetary regime.

PS Mr. Kuroda is saying he want to spend his vacation reading book. Good choice, but maybe he should also spend some time golfing. See here why.

PPS At some point I will have to write a blog post why I think the Japanese are making a mistake when they are implementing an inflation target rather than an NGDP level target.

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This blog post is also available in Japanese here.

Unfocused vacation musings on money – part 1

It is vacation time for the Christensen family. We are in the Christensen vacation home in Skåne (Southern Sweden) and my blogging might reflect that.

There are really a lot of things going on the in world and I would love to write a lot about it all, but there is not enough time. But here are a few observations about recent global events from a monetary perspective.

Egyptian Regime Uncertainty

I am not getting myself into commenting too much on what is going on in Egypt other than I fundamentally is quite upbeat on the Egyptian economy, which I easily could see growth 7-8% y/y in real terms in the next 1-2 decade (with the right reforms!)

Remember the Egyptian population is going from 80 to 90 million within the next decade and the labour will be growing by more than 1% a year in the same period (as far as I remember). With the right reforms that is a major growth boost. So Egypt is a major positive long-term supply side story – short-term it is a major negative supply side story.

What we have in Egypt is of course a spike in what Robert Higgs calls Regime Uncertainty. That is a negative supply shock. The Egyptian central bank should of course allow that to feed through to higher prices – don’t fight a supply shock with monetary policy. There is a lot to say about how Egyptian monetary policy should be different, but monetary policy surely is not Egypt’s biggest problem. If you want to understand Egypt’s problem I think you should read “Why Nations Fail”.

I earlier wrote a post on the implications of recent Turkish political unrest from an AD/AS perspective. I think that post easily could be copy-pasted to understand the economics of the Egyptian crisis.

A Polish deflationary monetary policy blunder

I have followed the Polish economy closely for well over a decade and I love the country. However, recently I have got quite frustrated with particularly the Polish central bank. Yesterday the Polish central bank (NBP) cut its key policy rate by 25bp. No surprise there, but the NBP also (wrongly) said it was the last rate cut in the rate cutting cycle.

Say what? Poland is likely to have deflation before then end of the year and real GDP growth is well-below trend-growth. Not to talk about NGDP growth, which has been slowing significantly. I am not sure the NBP chief Marek Belka realises, but it did not ease money policy yesterday. It tightened monetary policy.

When a central bank tells the markets it will cut interest rates (or expand the money base) less than the markets have been expecting then it is effectively monetary tightening. That was what the NBP did yesterday – pure and simply. Now ask yourself whether that is the right medicine for an economy heading for deflation soon. To me it is a deflationary monetary policy blunder. (I will not even say what I think of the recent FX intervention to prop up the Polish zloty).

A confident Kuroda should not be complacent

This morning Bank of Japan governor Kuroda had press conference on monetary and economic developments in Japan. I didn’t read up on the details – I am on vacation after all – but it seems like Mr. Kuroda was quite confident that what he is doing is working. I agree, but I would also tell Mr. Kuroda that he at best is only half way there. Inflation expectations are still way below his 2% inflation target so his policies are not yet credible enough to declare victory yet. So let me say it again – more work on communication is needed.

Carney’s long and variable leads (I would have hoped)

Mark Carney has only been Bank of England governor since Monday, but it is tempting to say that he is already delivering results. The macroeconomic data released this week for the UK economy have all been positive surprises and it looks like a recovery is underway in the British economy. So why am I saying that Carney is already delivering results? Well because monetary policy is working with long and variable leads as Scott Sumner likes to tell us. There is a wide expectation in the markets that Carney will “try to do something” to ease UK monetary policy and that in itself is monetary easing (this is the reverse of the Polish story above).

However, my story is unfortunately a lot less rosy. The fact is that the market is not totally sure that Carney will be able to convince his colleagues on the Monetary Policy Committee to do the right thing (NGDP targeting) and judging from the markets a major change in policy is not priced in. So Carney shouldn’t really take credit for the better than expected UK numbers – at least not a lot of credit. So there is still no excuse for not doing the right thing. Get to work on an NGDP level target right now.

Summertime reading…

I hope to be able to do some reading while on vacation – at least I brought a lot of books (yes, one of them is about Karl Marx). Take a look…

Vacation books

PS It is 4th of July today. The US declaration of independence is surely something to celebrate and here in the small city of Skyrup in Skåne our neighbour always fly the Stars and Stripes on July 4th so we won’t forget. I like that.

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