Mikio Kumada tells the right story about the Japanese GDP numbers

Earlier today we got numbers for Japanese GDP numbers for Q4 2014. Watch my friend Mikio Kumada comment on the numbers here.

I fully share Mikio’s optimistic reading of the numbers. Bank of Japan’s quantitative easing is working and is lifting nominal spending growth.

Does that solve all Japan’s problems? No certainly not. It cannot do anything about Japan’s structural problems – particularly the negative demographics – but it is pulling Japan out of the deflationary-trap. And that is exactly what BoJ governor Kuroda set out to do. Now Prime Minister Abe has to deliver on structural reform, but that can be said about every industrialized country in the world.

PS Yes, I am positive about the Bank of Japan’s policy actions, but I still think it would have been much better with a NGDP level target for Japan rather than a 2% inflation target.

Kuroda’s new team member – Yutaka Harada

If monetary policy is credible and strictly rules based who is running the central bank has little importance. However, if the central bank has not established full credibility then who is running the show will actually be important. Therefore, last week’s news that Yutaka Harada has been nominated for Bank of Japan’s board should certainly be noticed.

I personally have little knowledge of Professor Harada, but I of course have noticed that he has been both described as a “reflationist” and a “monetarist”.

Furthermore, it is notable that he is said to favour fiscal consolidation and structural reforms for Japan. This of course is as Scott Sumner notices the unique market monetarist “policy cocktail” that would be the right one for Japan in the present situation.

Harada’s monetarist insights

As I previously had not even heard of Harada I have done a bit of research on his views. Doing that I came across a paper – “Using Monetary Policy to End Stagnation” – he authored back in 2010. I am not sure Harada would describe himself as a monetarist, but his 2010 paper is certainly quite monetarist. Here is a few quotes…

First on the BOJ’s “restrictive policy”:

Compared with a growth strategy with indeterminate effects, stabilizing the value of the yen would produce quick results. Why has the yen become strong? The reason is a restrictive monetary policy. How can we say that policy has been tightened when interest rates remain so low? To answer this, we need to look at not interest rates but the money supply to see how much money is being fed into the economy.

Japan’s bias toward restrictive monetary control was excessive even in the wake of the global financial crisis…

…The BOJ argues that other countries needed to expand the monetary base in order to absorb the shock to their financial systems from the emergence of vast quantities of bad debts, and that Japan had no such need because domestic banks were not burdened by a heavy load of nonperforming loans. It is true that bad debts did not hobble Japan’s banks. Nonetheless, the global recession dealt a sharp shock to external demand, and the rising yen delivered a follow-up blow.

So we got a Hetzelian/Sumnerian explanation for the weak Japanese recovery after the “Lehman shock” in 2008 – the Japanese recovery in 2009-10 was weak because monetary policy was tight. The markets – the yen – is telling us that and low rates is not a sign a sign that monetary policy is easy.

So the crisis is one of weak demand, but Harada is skeptical that fiscal policy can be used to solve the problem:

Using fiscal policy to generate demand means stepping up government spending, which has to be paid for by either issuing government bonds or hiking taxes. Both of these funding methods involve collecting money from the public. Basically the government just takes money out of citizens’ right pockets and puts it back in their left pockets. Monetary policy works in a different way. A central bank is capable of expanding the money supply without limit. It can, for instance, buy government bonds and supply the market with funds. These are not funds it collects from the public, and so it can put money in citizens’ left pockets without taking anything from their right pockets.”

So Harada welcomes quantitative easing, but it needs to be done within a rule-based framework:

“Of course, adopting such a policy over an extended period of time would invite criticism, since it would trigger inflation and could wind up causing the kind of hyperinflation Zimbabwe has been suffering from. A policy of significantly expanding the money supply must therefore be left in place only for a while, after which the central bank must redirect its aim at a modest inflation rate of, say, 2%. This would be a policy of inflation targeting, and it provides one way of terminating more aggressive monetary relaxation.

Harada goes on to take on the traditional deflationist views of the BoJ (you could easily replace BoJ with ECB):

Although Japan’s prewar elite had some outstanding members, notably Takahashi Korekiyo, these days everyone seems to have swallowed the nonsensical line of the BOJ. Monetary policy, the bank argues, is not involved in the ongoing deflation. It points instead to such factors as inexpensive imports from China and other low-wage countries, price markdowns due to streamlining in distribution and deregulation, a sustained wage decline, and a lowering of growth expectations. Deflation is structural factor, the BOJ says, and no amount of money supply expansion would bring it to a stop.

We need to note, however, that whereas China is exporting low-priced goods around the world, it is only in Japan that prices are falling. Distribution streamlining and deregulation may well cause prices to drop, but they should also be expected to speed up the economy’s growth rate, and that has not occurred. Wages are indeed in the midst of a downward trend, but that is because of the ongoing deflation and business slump, which have been caused by the BOJ’s passive policy stance. Companies are hardly likely to hike wages at a time of falling prices and slim profits. An expectation of slower growth in the future is a certainly a cause of diminished demand, since many people will tighten their purse strings, but that does not automatically make it a deflationary factor. Slower growth would also cause future supply to diminish, and that would be an inflationary factor. Supply and demand factors are both involved in price movements, and we would need to know which is larger before calling lowered expectations a deflationary force.

And finally echoing Milton Friedman Harada explains the relationship between the stance of monetary policy and the level of interest rates:

“Here we should note that interest rates are low today not because the BOJ has adopted a policy of easy money but because it is sticking to a policy that is fostering deflation. If the BOJ had acted in the same way the Bank of Korea did when it expanded the monetary base to deal with the global financial crisis, probably the yen would not have appreciated, exports would not have dropped so far, and employment would not have been cut back so sharply. Japanese production would have recovered in tandem with the recovery of the world economy, and prices would not have fallen. With output expanding, profits would have improved, and both real and nominal GDP would have increased. All this would have set the stage for expectations of an upturn, and short- and long-term interest rates would have risen.”

We will see how Yutaka Harada actually performs on the BoJ’s board, but I think it is fair to say that the BoJ will take a step further in a monetarist direction with the nomination of Yutaka Harada to the BoJ board.

Tighter monetary conditions – not lower oil prices – are pushing down inflation expectations

Oil prices are tumbling and so are inflation expectations so it is only natural to conclude that the drop in inflation expectations is caused by a positive supply shock – lower oil prices. However, that is not necessarily the case. In fact I believe it is wrong.

Let me explain. If for example 2-year/2-year euro zone inflation expectations drop now because of lower oil prices then it cannot be because of lower oil prices now, but rather because of expectations for lower oil prices in the future.

2y2y BEI euro zone

But the market is not expecting lower oil prices (or lower commodity prices in general) in the future. In fact the oil futures market expects oil prices to rise going forward.

Just take a look at the so-called 1-year forward premium for brent oil. This is the expected increase in oil prices over the next year as priced by the forward market.

brent 1-year foreard

Oil prices have now dropped so much that market participants now actually expect rising oil prices over the going year.

Hence, we cannot justify lower inflation expectations by pointing to expectations for lower oil prices – because the market actual expects higher oil prices – more than 2.5% higher oil prices over the coming year.

So it is not primarily a positive supply shock we are seeing playing out right now. Rather it is primarily a negative demand shock – tighter monetary conditions.

Who is tightening? Well, everybody -The Fed has signalled rate hikes next year, the ECB is continuing to failing to deliver on QE, the BoJ is allowing the strengthening of the yen to continue and the PBoC is allowing nominal demand growth to continue to slow.

As a result the world is once again becoming increasingly deflationary and that might also be the real reason why we are seeing lower commodity prices right now.

Furthermore, if we were indeed primarily seeing a positive supply shock – rather than tighter global monetary conditions – then global stock prices would have been up and not down.

I can understand the confusion. It is hard to differentiate between supply and demand shocks, but we should never reason from a price change and Scott Sumner is therefore totally correct when he is saying that we need a NGDP futures market as such a market would give us a direct and very good indicator of whether monetary/demand conditions are tightening or not.

Unfortunately we do not have such a market and there is therefore the risk that central banks around the world will claim that the drop in inflation expectations is driven by supply factors and that they therefore don’t have to react to it, while in fact global monetary conditions once again are tightening.

We have seen it over and over again in the past six years – monetary policy failure happens when central bankers fail to differentiate properly between supply and demand shocks. Hopefully this time they will realized the mistake before things get too bad.

PS I am not arguing that the drop in actual inflation right now is not caused by lower oil prices. I am claiming that lower inflation expectations are not caused by an expectation of lower oil prices in the future.

PPS This post was greatly inspired by clever young colleague Jens Pedersen.

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.

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…

Tick tock…here comes the Zero Lower Bound again

This week have brought even more confirmation that we are still basically in a deflationary world – particularly in Europe. Hence, inflation numbers for October in a number of European countries published this week confirm that that inflation is declining markedly and that we now very close to outright deflation in a number of countries. Just take the case of the Czech Republic where the so-called monetary policy relevant inflation dropped to 0.1% y/y in October or even worse Sweden where we now have outright deflation – Swedish consumer prices dropped by 0.1% in October compared to a year ago.

And the picture is the same everywhere – even a country like Hungary where inflation notoriously has been above the central bank’s 3% inflation target inflation is now inching dangerously close to zero.

Some might say that there is no reason to worry because the recent drop in inflation is largely driven by supply side factors. I would agree that we shouldn’t really worry about deflation or disinflation if it is driven by a positive supply shocks and central banks would not react to such shocks if they where targeting nominal GDP rather than headline consumer price inflation. In fact I think that we are presently seeing a rather large positive supply shock to the global economy and in that sense the recent drop in inflation is mostly positive. However, the fact is that the underlying trend in European prices is hugely deflationary even if we strip out supply side factors.

Just the fact that euro zone money supply growth have averaged 0-3% in the past five years tells us that there is a fundamental deflationary problem in the euro zone – and in other European countries. The fact is that inflation has been kept up by negative supply shocks in the past five years and in many countries higher indirect taxes have certainly also helped kept consumer price inflation higher than otherwise would have been the case.

So yes supply side factors help drag inflation down across Europe at the moment – however, some of this is due to the effect of earlier negative supply side shocks are “dropping out” of the numbers and because European governments are taking a break from the austerity measures and as a result is no longer increasing indirect taxes to the same extent as in earlier years in the crisis. Hence, what we are no seeing is to a large extent the real inflation picture in Europe and the fact is that Europe to a very large extent is caught in a quasi-deflatonary trap not unlike what we had in Japan for 15 years.

Here comes the Zero Lower Bound

Over the past five years it is not only the ECB that stubbornly has argued that monetary policy was easy, while it in fact was über tight. Other European central banks have failed in a similar manner. I could mention the Polish, the Czech central banks and the Swedish Riksbank. They have all to kept monetary policy too tight – and the result is that in all three countries inflation is now well-below the central bank’s inflation targets. Sweden already is in deflation and deflation might very soon also be the name of the game in the Czech Republic and Poland. It is monetary policy failure my friends!

In the case of Poland and Sweden the central banks have had plenty of room to cut interest rates, but both the Polish central bank and the Swedish Riksbank have been preoccupied with other issues. The Riksbank has been busy talking about macro prudential indicators and the risk of a property market bubble, while the economy has slowed and we now have deflation. In fact the Riksbank has consistently missed its 2% inflation target on the downside for years.

In Poland the central bank for mysteries reasons hiked interest rates in early 2012 and have ever since refused to acknowledged that the Polish economy has been slowing fairly dramatically and that inflation is likely to remain well-below its official 2.5% inflation target. In fact yesterday the Polish central bank published new forecasts for real GDP growth and inflation and the central bank forecasts inflation to stay well-below 2.5% in the next three years and real GDP is forecasted to growth much below potential growth.

If a central bank fails to hit its inflation target blame the central bank and if a central bank forecasts three years of failure to hit the target something is badly wrong. Polish monetary policy remains overly tight according to it own forecasts!

The stubbornly tight monetary stance of the Polish, the Czech and the Swedish central banks over the past couple of years have pushed these countries into a basically deflationary situation. That mean that these central banks now have to ease more than would have been the case had they not preoccupied themselves with property prices, the need for structural reforms and fiscal policy in recent years. However, as interest rates have been cut in all three countries – but too late and too little – we are now inching closer and closer to the Zero Lower Bound on interest rates.

In fact the Czech central bank has been there for some time and the Polish and the Swedish central bank might be there much earlier than policy makers presently realise. If we just get one “normal size” negative shock to the European economy and then the Polish and Swedish will have eventually to cut rates to zero. In fact with Sweden already in deflation one could argue that the Riksbank already should have cut rates to zero.

The Swedish and the Polish central banks are not unique in this sense. Most central banks in the developed world are very close to the ZLB or will get there if we get another negative shock to the global economy. However, most of them seem to be completely unprepared for this. Yes, the Federal Reserve now have a fairly well-defined framework for conducting monetary policy at the Zero Lower Bound, but it is still very imperfect. Bank of Japan is probably closer to having a operational framework at the ZLB. For the rest of the central banks you would have to say that they seem clueless about monetary policy at the Zero Lower Bound. In fact many central bankers seem to think that you cannot ease monetary policy more when you hit the ZLB. We of course know that is not the case, but few central bankers seem to be able to answer how to conduct monetary policy in a zero interest rate environment.

It is mysteries how central banks in apparently civilised and developed countries after five years of crisis have still not figured out how to combat deflation with interest rates at the Zero Lower Bound. It is a mental liquidity trap and it is telling of the serious institutional dysfunctionalities that dominate global central banking that central bankers are so badly prepared for dealing with the present situation.

But it is nonetheless a fact and it is hard not to think that we could be heading for decades of deflation in Europe if something revolutionary does not happen to the way monetary policy is conducted in Europe – not only by the ECB, but also by other central banks in Europe. In that sense the track record of the Swedish Riksbank or the Polish and Czech central banks is not much better than that of the ECB.

We can avoid deflation – it is easy!

Luckily there is a way out of deflation even when interest rates are stuck at zero. Anybody reading the Market Monetarists blogs know this and luckily some central bankers know it as well. BoJ chief Kuroda obviously knows what it takes to take Japan out of deflation and he is working on it. As do Czech central bank chief Miroslav Singer who last week – finally  – moved to use the exchange rate as policy instrument and devalued the Czech kurona by introducing a floor on EUR/CZK of 27. By doing this he copied the actions of the Swiss central bank. So there is hope.

Some central bankers do understand that there might be an Zero Lower Bound, but there is no liquidity trap. You can always avoid deflation. It is insanely easy, but mentally it seems to be a big challenge for central bankers in most countries in the world.

I am pretty optimistic that the Fed’s actions over the past year is taking the US economy out of the crisis. I am optimistic that the Bank of Japan will win the fight against deflation. I am totally convinced that the Swiss central bank is doing the right thing and I am hopeful that Miroslav Singer in the Czech Republic is winning the battle to take the Czech economy out of the deflationary trap. And I am even optimistic that the recent global positive supply shock will help lift global growth.

However, the ECB is still caught in its own calvinist logic and seems unable to realise what needs to be done to avoid a repeat of the past failures of the Bank of Japan. The Swedish central bank remains preoccupied with macro prudential stuff and imaginary fears of a property market bubble, while the Swedish economy now caught is in a deflationary state. The Polish central bank continues to forecast that it will fail to meet its own inflation target, while we are inching closer and closer to deflation. I could mention a number of other central banks in the world which seem trapped in the same kind of failed policies.

Ben Bernanke once argued that the Bank of Japan should show Rooseveltian resolve to bring Japan out of the deflationary trap. Unfortunately very few central bankers in the world today are willing to show any resolve at all despite the fact that we at least Europe is sinking deeper and deeper into a deflationary trap.

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Update: Former Riksbank deputy governor Lars E. O. Svensson comments on the Swedish deflation. See here.

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?

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