All posts tagged Japan

Japan: It’s domestic demand, stupid

I have been reading the reports on the Japanese trade data for April, which have been published this morning. The reporting is extremely telling about how most journalists (and economists!) fail to understand what is going on in Japan (the markets understand perfectly well – Nikkei is nicely up this morning).

In nearly all the reports on the data there is a 90% focus on the fact that exports grew slower than expected (3.8% y/y) and that the Japanese trade deficit remains in place. The slightly “disappointing” numbers is then in most news stories used to speculate that Bank of Japan’s monetary easing is not working – or rather the weaker yen has failed to boost exports as much as expected. On the other hand there is nearly no focus on the import data, which grew by nearly 10% y/y.

It is really the strong import growth, which is the interesting story here. As I earlier have argued the monetary easing in Japan is likely to boost domestic demand rather than net exports. This is from my latest post on BoJ:

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….

…When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

And this of course is exactly what we are now seeing in the data. Export growth continues to accelerate, but import growth accelerates even faster and the trade data is worsening. That is very good news – monetary policy is boosting domestic demand. Mr. Kuroda please keep up the good work.

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9 Comments
by Lars Christensen on May 22, 2013  •  Permalink
Posted in Bank of Japan, Haruhiko Kuroda, Japan
Tagged , ,

Posted by Lars Christensen on May 22, 2013

http://marketmonetarist.com/2013/05/22/japan-its-domestic-demand-stupid/

The Kuroda recovery will be about domestic demand and not about exports

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

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.

The weaker yen is an indicator of monetary easing – but not the main driver of growth

I think that the way we should think about the weaker yen is as a 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.

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 expect 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. So it is no wonder that equity analysts feel more optimistic about Japanese companies’ earnings.

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”.

The focus on competitiveness is completely misplaced

I have in numerous earlier posts argued that when a country is going through a “devaluation” as a consequence of monetary easing the important thing is not competitiveness, but the impact on domestic demand.

I have for example earlier demonstrated that Swedish growth outpaced Danish growth in 2009-10 not because the Swedish krona depreciated strongly against the Danish krone (which is pegged to the euro), but because the Swedish Riksbank was able to ease monetary policy, while the Danish central bank effectively tightened monetary conditions due to the Danish fixed exchange rate policy. As a consequence domestic demand did much better in Sweden in 2009-10 than in Denmark, while – surprise, surprise – Swedish and Danish exports more or less grew at the same pace in 2009-10 (See graphs below).

Similarly I have earlier shown that when Argentina gave up its currency board regime in 2002 the major boost to growth did not primarly come from exports, but rather from domestic demand. Let me repeat a quote from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

And if we want to go further back in history we can look at what happened in the US after FDR gave up the gold standard in 1933. Here the story was the same – it was domestic demand and not net exports which was the driver of the sharp recovery in growth during 1933.

These examples in my view clearly shows that 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.

Finally if anybody still worry about “currency war” they might want to rethink how they see the impact of monetary easing. When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

HT Jonathan Cast

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PS Scott Sumner also comments on Japan.

PPS An important non-competitiveness impact of the weaker yen is that it is telling consumers and investors that inflation is likely to increase. Again the important thing is the signal about monetary policy, which is rather more important than the impact on competitiveness.

50 Comments
by Lars Christensen on May 10, 2013  •  Permalink
Posted in Argentina, Denmark, Haruhiko Kuroda, Liquidity trap, Sweden, Transmission mechanism
Tagged , , , , , , , , ,

Posted by Lars Christensen on May 10, 2013

http://marketmonetarist.com/2013/05/10/the-kuroda-recovery-will-be-about-domestic-demand-and-not-about-exports/

Monetary policy works just fine – Exhibit 14743: The case of Japanese earnings

The graph below shows the ratio of upward to downward revisions of equity analysts’ earnings forecasts in different countries. I stole the graph from Walter Kurtz at Sober Look. Walter himself got the data from Merrill Lynch.

Just take a look in the spike in upward earnings revisions (relative to downward revision) for Japanese companies after Haruhiko Kuroda was nominated for new Bank of Japan governor back in February and he later announced his aggressive plan for hitting the newly introduced 2% inflation target.

This is yet another very strong prove that monetary policy can be extremely powerful. The graph also shows the importance of the Chuck Norris effect – monetary policy is to a large extent about expectations or as Scott Sumner would say: Monetary Policy works with long and variable leads - or rather I believe that the leads are not very long and not very variable if the central bank gets the communication right and I believe that the BoJ is getting the communication just right so you are seeing a fairly strong and nearly imitate impact of the announced monetary easing.

PS As there tend to be a quite strong positive correlation between earning growth and nominal GDP growth I think we can safely say that the sharp increase in earnings expectations in Japan to a large extent reflects a marked upward shift in NGDP growth expectations.

8 Comments
by Lars Christensen on May 9, 2013  •  Permalink
Posted in Bank of Japan, Chuck Norris Effect, Haruhiko Kuroda, Japan, Scott Sumner
Tagged , , , ,

Posted by Lars Christensen on May 9, 2013

http://marketmonetarist.com/2013/05/09/monetary-policy-works-just-fine-exhibit-14743-the-case-of-japanese-earnings/

Answering Tyler’s question on Japan with old blog post

Here is Tyler Cowen on Twitter:

Still not seeing much discussion of 4.1% unemployment rate in Japan, would love to see “jump start” defined.

What Tyler is basically saying is that there really is not an argument for “jump starting” the Japanese economy with fiscal and monetary stimulus when unemployment is this low. I many ways I share Tyler’s skepticism about “stimulus” in the case of Japan.

I have long argued that Japanese story is a lot more complicated than it is normally said to be (my first post on the topic was: “Japan’s deflation story is not really a horror story” from October 2011). It is correct that Japan’s lost decade was not a story of two lost decades and in my view quantitative easing ended the “lost decade” in 2001. This is what I said in my post “Japan shows that QE works”

In early 2001 the Bank of Japan finally decided to listen to the advise of Milton Friedman and as the graph clearly shows this is when Japan started to emerge from the lost decade and when real GDP/capita started to grow in line with the other G7 (well, Italy was falling behind…).

The actions of the Bank of Japan after 2001 are certainly not perfect and one can clearly question how the BoJ implemented QE, but I think it is pretty clearly that even BoJ’s half-hearted monetary easing did the job and pull Japan out of the depression. In that regard it should be noted that headline inflation remained negative after 2001, but as I have shown in my previous post Bank of Japan managed to end demand deflation (while supply deflation persisted).

And yes, yes the Bank of Japan of course should have introduces much clearer nominal target (preferably a NGDP level target) and yes Japan has once again gone back to demand deflation after the Bank of Japan ended QE in 2007. But that does not change that the little the BoJ actually did was enough to get Japan growing again.

This graph of GDP/capita in the G7 countries illustrates my point:

g7rgdpcap

As I said in my earlier post: “A clear picture emerges. Japan was a star performer in 1980s. The 1990s clearly was a lost decade, while Japan in the past decade has performed more or less in line with the other G7 countries. In fact there is only one G7 country with a “lost decade” over the paste 10 years and that is Italy.”

Hence, Japan came out of the crisis from 2001. However, it should also be noted that Japan has once again fallen into crisis and more importantly Japan’s monetary policy certainly is not based on a rule based framework so the risk that Japan will continue to fall back into crisis remains high. This in my view is a discussion about securing Japan a “Monetary constitution” rather than about stimulus. Unfortunately Prime Minister Abe’s new government do seem to be more focused on short-term stimulus rather than on real institutional reform.

There is no such thing as fiscal policy

– and that goes for Japan as well

The Abe government is not only pursuing expansionary monetary policies, but has also announced that it wants to ease fiscal policy dramatically. This obviously will scare any Market Monetarist – or anybody who are simply able to realise that there is a budget constrain that any government will have to fulfill in the long-run.

This is what I earlier have said on the fiscal issue in the case of Japan:

Furthermore, it is clear that Japan’s extremely weak fiscal position to a large extent can be explained by the fact that BoJ de facto has been targeting 0% NGDP growth rather than for example 3% or 5% NGDP growth. I basically don’t think that there is a problem with a 0% NGDP growth path target if you start out with a totally unleveraged economy – one can hardly say Japan did that. The problem is that BoJ changed its de facto NGDP target during the 1990s. As a result public debt ratios exploded. This is similar to what we see in Europe today.

So yes, it is obvious that Japan can’t not afford “fiscal stimulus” – as it today is the case for the euro zone countries. But that discussion in my view is totally irrelevant! As I recently argued, there is no such thing as fiscal policy in the sense Keynesians claim. Only monetary policy can impact nominal spending and I strongly believe that fiscal policy has very little impact on the Japanese growth pattern over the last two decades.

Above I have basically added nothing new to the discussion about Japan’s lost decade (not decades!) and fiscal and monetary policy in Japan, but since Scott brought up the issue I thought it was an opportunity to remind my readers (including Scott) that I think that the Japanese story is pretty simple, but also that it is wrong that we keep on talking about Japan’s lost decades. The Japanese story tells us basically nothing new about fiscal policy (but reminds us that debt ratios explode when NGDP drops), but the experience shows that monetary policy is terribly important.

My advise: Target an 3% NGDP growth level path and balance the budget 

My advise to the Abe government would therefore be for the Bank of Japan to introduce proper monetary policy rules and I think that an NGDP level targeting rule targeting a growth path of 3% would be suiting for Japan given the negative demographic outlook for Japan. Furthermore, if the BoJ where to provide a proper framework for nominal stability then the Japanese government should begin a gradual process of fiscal consolidation by as soon as possible to bring the Japanese budget deficit back to balance. With an NGDP growth path of 3% Japanese public debt as a share of GDP would gradually decline in an orderly fashion on such fiscal-monetary framework.

So what Japan needs is not “stimulus” – neither fiscal nor monetary – but rather strict rules both for monetary policy and fiscal policy. The Abe government has the power to ensure that, but I am not optimistic that that will happen.

Earlier posts on Japan:

There is no such thing as fiscal policy – and that goes for Japan as well
The scary difference between the GDP deflator and CPI – the case of Japan
Friedman’s Japanese lessons for the ECB
There is no such thing as fiscal policy – and that goes for Japan as well
Japan shows that QE works
Did Japan have a “productivity norm”?
Japan’s deflation story is not really a horror story

PS even though I am skeptical about the way Shinzo Abe are going about things and I would have much preferred a rule based framework for Japan’s monetary and fiscal policy I nonetheless believe that the Abe government’s push for particularly monetary “stimulus” is likely to spur Japanese growth and is very likely to be good news for a global economy badly in need of higher growth.

Update: Scott Sumner also comments on Japan and it seems like we have more or less the same advise. Here is Scott:

“Just to be clear, my views are somewhere between those of Feldstein and the more extreme Keynesians.  I agree with Feldstein that Japan has big debt problems and big structural problems, and needs to address both.  And that fiscal stimulus is foolish (as even Adam Posen recently argued.)  Unlike Feldstein I also think they have an AD problem that calls for modestly higher inflation and NGDP growth.  At a minimum they should be shooting for 2% to 3% NGDP growth, instead of the negative NGDP growth of the past 20 years.”

1 Comment
by Lars Christensen on January 19, 2013  •  Permalink
Posted in Bank of Japan, Japan, Shinzo Abe
Tagged , , ,

Posted by Lars Christensen on January 19, 2013

http://marketmonetarist.com/2013/01/19/answering-tylers-question-on-japan-with-old-blog-post/

Ambrose on Abe

Here is our friend Ambrose Evans-Pritchard in the Daily Telegraph:

Japan’s incoming leader Shinzo Abe has vowed to ram through full-blown reflation policies to pull his country out of slump and drive down the yen, warning Japan’s central bank not to defy the will of the people.

…The profound shift in economic strategy by the world’s top creditor nation could prove a powerful tonic for the global economy, with stimulus leaking into bourses and bond markets – a variant of the “carry trade” earlier this decade but potentially on a larger scale.

…”It is tremendously important for global growth, and markets are starting to take note,” said Lars Christensen from Danske Bank.

Mr Abe’s Liberal Democratic Party (LDP) won a landslide victory on Sunday, securing a two-thirds “super-majority” in the Diet with allies that can override senate vetoes.

Armed with a crushing mandate, Mr Abe said he would “set a policy accord” with the Bank of Japan for a mandatory inflation target of 2pc, backed by “unlimited” monetary stimulus.

“Its very rare for monetary policy to be the focus of an election. We campaigned on the need to beat deflation, and our argument has won strong support. I hope the Bank of Japan accepts the results and takes an appropriate decision,” he said.

Mr Abe plans to empower an economic council to “spearhead” a shift in fiscal and monetary strategy, eviscerating the central bank’s independence.

The council is to set a 3pc growth target for nominal GDP, embracing a theory pushed by a small band of “market monetarists” around the world. “This is a big deal. There has been no nominal GDP growth in Japan for 15 years,” said Mr Christensen.

Did I just say that NGDP hasn’t grown for 15 years in Japan? Yes, I did…it is actually worse – Japanese nominal GDP is 10% lower today than in 1997.

NGDP Japan

The ECB is the only one of the major central banks in the world that is not at the moment taking decisive steps in the direction of getting out of the deflationary scenario. I hope we don’t have to wait 15 years for the ECB to do the right thing. The Japanese experience should be a major warning to European policy makers.

If you don’t think you can compare Europe today and Japan in 1997 then maybe you should should take a look at this post.

PS a friend of mine who once spent time at the BoJ is telling me not to get overly optimistic…

PPS Matt Yglesias also comments on Abe.

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Previous posts on Japan:

Japan shows that QE works
Did Japan have a “productivity norm”?
There is no such thing as fiscal policy – and that goes for Japan as well
Friedman’s Japanese lessons for the ECB
The scary difference between the GDP deflator and CPI – the case of Japan

3 Comments
by Lars Christensen on December 17, 2012  •  Permalink
Posted in Bank of Japan, ECB, Japan, Robert Hetzel, Shinzo Abe
Tagged , , , ,

Posted by Lars Christensen on December 17, 2012

http://marketmonetarist.com/2012/12/17/ambrose-on-abe/

BoJ might become the first central bank in the world to introduce NGDP targeting

I stole this from Britmouse (who got it from Bloomberg):

Abe advocates increased monetary easing to reverse more than a decade of falling prices and said he would consider revising a law guaranteeing the independence of the Bank of Japan. (8301) In an economic policy plan issued yesterday, the LDP said it would pursue policies to attain 3 percent nominal growth.

Talk about good news! Shinzo Abe of course is the leader of Japan’s main opposition party the Liberal Democratic Party (LDP). LDP is favourite to win the upcoming Japanese parliament elections – so soon Japan might have a Prime Minister who favours NGDP targeting.

So how could this be implemented? Well, Lars E. O. Svensson has a solution and I am pretty sure he would gladly accept the job if Abe offered him to become new Bank of Japan governor. After all he does not seem to happy with his colleagues at the Swedish Riksbank at the moment.

PS I would love to get in contact with any Japanese economist interested in NGDP targeting – please drop me a mail (lacsen@gmail.com)

PPS I can recommend vacation in Langkawi Malaysia – this is lunch time blogging in the shadow of the palms

Update: Oops – Scott also comments on this story.

8 Comments
by Lars Christensen on November 18, 2012  •  Permalink
Posted in Bank of Japan, Japan, NGDP Targeting, Nominal Income Targeting, Shinzo Abe
Tagged , , , ,

Posted by Lars Christensen on November 18, 2012

http://marketmonetarist.com/2012/11/18/boj-might-become-the-first-central-bank-in-the-world-to-introduce-ngdp-targeting/

Patri Friedman on Market Monetarism

Here is Patri Friedman on his blog “Patri’s Peripatetic Peregrinations”:

“I sent a friend an intro to market monetarism (a modern, blogosphere-inspired adjustment to the traditional monetarism my grandfather helped create). He was surprised I believed that printing money could be good, rather than agreeing with the Austrians.”

I am happy to see that Patri has read my paper on Market Monetarism.

There is of course nothing wrong in thinking that “printing money could be good” (under certain circumstances). In fact this is completely in line with what Patri’s grandfather Milton Friedman argued in terms of the Great Depression and the Japanese crisis.

Patri in his post also discusses how a “helicopter drop” could happen in a world of digital cash. Interestingly enough this discussion is similar to a recent internal Market Monetarist debate between Nick Rowe, Bill Woolsey and Scott Sumner about whether money is a medium of exchange or a medium of account. See for example here, here and here. Kurt Schuler also has contributed to the discussion. Finally Miles Kimball similarly has a very interesting post on the case for electronic money.

Patri’s discussion of digital cash to some extent also relates to my own discussion of monetary reform in Africa and the development of mobile based money (See for example here, here, here and here).

Anyway, I am happy to Patri seems to be showing some sympathy for Market Monetarism.

HT Lasse Birk Olesen

6 Comments
by Lars Christensen on November 11, 2012  •  Permalink
Posted in Bill Woolsey, Kurt Schuler, Lars E. O. Svensson, Miles Kimball, Nick Rowe, Patri Friedman, Project African Monetary Reform, Project African Monetary Reform (PAMR), Scott Sumner, The Great Depression
Tagged , , , , , , , ,

Posted by Lars Christensen on November 11, 2012

http://marketmonetarist.com/2012/11/11/patri-friedman-on-market-monetarism/

The ECB is turning into the BoJ

This is ECB Chief Mario Draghi:

“Well, let me first just point out that I never mentioned deflation. Deflation is a generalised fall in the price level across sectors and it is self-sustaining. And so far we have not seen signs of deflation, neither at the euro area level nor at country level. We should also be very careful about not mixing up what is a normal price readjustment due to the restoration of competitiveness in some of these countries. They will necessarily have to go through a re-adjustment of prices. We should not confuse this readjustment of prices, which is actually welcome, with deflation. Basically, we see price behaviour in line with our medium-term objectives. So, we see price stability over the medium term. Also consider that monetary policy is already very accommodative, consider the very low level of interest rates and that real interest rates are negative in a large part of the euro area…”

When I read Draghi’s comments the first thing I came to think of was how much this sounds like comments from Bank of Japan officials over the last 15 years.

Maybe Mario Draghi would be interested in this graph. It show the growth of broad money in the euro zone and Japan. I have constructed the graph so the growth of money peaks more or less at the same time in the graph for Japan and the euro zone. M2 growth peaked around 1990 in Japan and 2008 in the euro zone. The graph clearly shows both the boom and the bust and for Japan a very long period – more than a decade – of very low money supply growth.

I basically hate this kind of graph but the similarity is hard to miss. If Mario Draghi thinks euro zone monetary policy is “accommodative” today then he would also have to think Japanese monetary policy was accommodative in 1994-94.

BUT worse if the ECB continues on it’s present path it will likely repeat the mistakes of the BoJ and then we might be in for years of deflation. I know that this is not what Draghi wants, but the ECB’s present policy is unfortunately not giving much hope that a Japanese scenario can be avoided.

By the way that is the real reason for the slump we are seeing in global stock markets these days and it likely has very little to do with Obama’s reelection and the fear of the “fiscal cliff”. It is mostly about the escalation of bad news out of Europe. I hope Draghi will soon realize that unless he shows some Rooseveltian Resolve then the bad news will continue for another decade.

3 Comments
by Lars Christensen on November 9, 2012  •  Permalink
Posted in ECB, euro crisis, Japan
Tagged , , ,

Posted by Lars Christensen on November 9, 2012

http://marketmonetarist.com/2012/11/09/the-ecb-is-turning-into-the-boj/

The scary difference between the GDP deflator and CPI – the case of Japan

Most inflation targeting central banks in the world are targeting inflation measured by the Consumer Price Index (CPI). However, if you want to target inflation CPI is probably the worst possible measure to focus on. Why? Because CPI includes both indirect taxes and import prices – something the central bank can certainly not control.

If the central bank targets CPI it would in fact have to tighten monetary policy in response to negative supply shocks such as rising oil prices. Similarly the CPI targeting central bank would effectively be “forced” to tighten monetary policy in response increases in indirect taxes. Do you think this is foolish? Well, the ECB is doing it all the time…just think of the catastrophic rate hikes in 2011 in response to higher oil prices and austerity induced indirect tax increases across the euro zone.

A much better measure to target – if you want to maintain an inflation targeting (I don’t…) – would be to target the so-called GDP deflator as this measure of prices by definition excludes import prices and indirect taxes. Targeting the GDP deflator therefore would reduce the problem of monetary policy reacting to positive and negative supply shocks.

You might think that the difference between CPI and the GDP deflator is small and frankly speaking that used my view. However, the difference is far from trivial, which the case of Japan’s deflationary experience over the past 15-17 years clearly illustrates. The graph below shows the development in the Japanese price level measured by both CPI and the GDP deflator.

While CPI indicates that the Japanese price level today is around 2% lower than in 1995 the GDP deflator is telling us that prices have dropped nearly 20% in the last 17 years. The difference is stunning and is certainly not something that should be ignored, but unfortunately I doubt that most central bankers are aware about just how great these differences are.

It should of course be stressed that it is not normally so that CPI will be upward biased compared to the GDP deflator, but if tight monetary policy is leading to long periods of low or no growth and that forces the government to increase indirect taxes to improve public finances – as it has been the case in Japan – then there very likely will be an upward biased in the CPI compared to the GDP deflator.

This conclusion obviously is highly relevant for the conduct of monetary policy in the present situation – particularly in the euro zone, where governments around Europe are increasing indirect taxes in a more or less desperate attempt to improve public finances. With the ECB’s focus on consumer prices (the HICP in the euro zone) rather than on the GDP deflator higher indirect taxes implicitly leads to tighter monetary policy – something which is hardly warranted in the present situation.

Therefore if central banks want to continue targeting inflation they should at least change from CPI targeting to GDP deflator targeting – that would be a small, but important step away from repeating the Japanese scenario.

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PS This discussion is less relevant for the Federal Reserve as the Fed is targeting a the PCE core inflation measure, which is much closer to the GDP deflator than to CPI.

Related posts:

The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Failed monetary policy – the one graph version

10 Comments
by Lars Christensen on November 6, 2012  •  Permalink
Posted in Inflation, Inflation Targeting, Japan
Tagged , ,

Posted by Lars Christensen on November 6, 2012

http://marketmonetarist.com/2012/11/06/the-scary-difference-between-the-gdp-deflator-and-cpi-the-case-of-japan/

Paul Krugman warns against fiscal stimulus

This is Paul Krugman on the effectiveness on fiscal policy and why fiscal “stimulus” will in fact not be stimulative:

“The US is currently engaged in the largest peacetime fiscal stimulus in history, with a budget deficit of around 10 percent of GDP. And this stimulus is working in the narrow sense that it has headed off the imminent risk of a deflationary spiral, and generated some economic growth. On the other hand, deficits this size cannot be continued over the long haul; USA now has Italian (or Belgian) levels of internal debt, together with large implicit liabilities associated with its awkward demographics. So the current strategy can work in the larger sense only if it succeeds in jump-starting the economy, in eventually generating a self-sustaining recovery that persists even after the stimulus is phased out.

Is this likely? The phrase “self-sustaining recovery” trips lightly off the tongue of economic officials; but it is in fact a remarkably exotic idea. The purpose of this note is to expose this hidden exoticism – to show that anyone who believes that temporary fiscal stimulus will produce sustained recovery is implicitly endorsing a rather fancy economic model, the sort of model that finance ministries would under normal circumstances regard as implausible and disreputable…

…What continues to amaze me is this: USA’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.”

Wauw! What is this? What happened to the keynesian Krugman? Isn’t he calling for fiscal easing anymore? Well yes, but I am cheating here. This is Paul Krugman, but it is not today’s Paul Krugman. This is Paul Krugman in 1999 – and he is talking about Japan and not the US. I simply replaced “Japan” with “the US” in the Krugman quote above.

Read the entire article here.

HT Tyler Cowen and Vaidas Urba.

15 Comments
by Lars Christensen on October 26, 2012  •  Permalink
Posted in Fiscal policy, Japan, Paul Krugman, Tyler Cowen
Tagged , , ,

Posted by Lars Christensen on October 26, 2012

http://marketmonetarist.com/2012/10/26/paul-krugman-warns-against-fiscal-stimulus/

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