Kuroda still needs to work on communication

Bank of Japan governor Haruhiko Kuroda must feel relieved as attention has turned away from sharply rising bond yields and a sharp set-back in the Nikkei to bad Federal Reserve communication and market turmoil in China. And I am sure that he like me have noticed that Nikkei has outperformed most major global stock markets in recent weeks. That could seem like a vindication of BoJ’s policies and to extent it is. However, I would cautious against too much optimism. Kuroda still needs to work on this communication.

Two things have been notable about the recent global financial turmoil in regard to Japan. First, as mentioned the Nikkei as outperformed other major global stock markets. Second, the yen has not strengthened nearly as much as it “normally” would have done in a situation of a sharp increase in global risk aversion. This could indicate that investors expect the BoJ to offset any shock to Japanese aggregate demand from global factors. That is good news and an indication that the BoJ has gained some credibility.

However, all it not well. The BoJ is targeting 2% inflation so that is really the only true measure we can use to judge BoJ’s success. Judging from inflation expectations the BoJ is still far away from having been successful. In fact if anything we are only half way there and as global inflation expectations have dropped back recently so have Japanese inflation expectations.

Last week we got the news that the Japanese government will resume the issuance of inflation-linked bonds. That is good news because I strongly believe that that is the most important communication and policy instrument available to the BoJ. Now the BoJ should start using market expectations for inflation a lot more actively in its communication. Mr. Kuroda should not waste any opportunity to say “while we have made progress in fighting deflation inflation expecations are still well-below our 2% inflation and we will do everything to push up inflation expectations until the markets price in 2% inflation on all relevant time horizons”. In fact this is more or less the only thing Mr. Kuroda needs to say.

Similarly regarding the recent “China turmoil” Mr. Kuroda should note  that “we have noticed the recent turmoil in global markets and that has put downward pressure on global inflation expectations. We will obviously do everything to offset any negative impact on Japanese inflation expectations.” 

Obviously I don’t think an inflation targeting regime is optimal and I would much have preferred that the BoJ had been targeting the NGDP level. However, given the inflation target the BoJ needs to make the best of it. Therefore, Mr. Kuroda should continue to repeat the message to markets: “We target 2% inflation so that is what markets should expect us to hit”.

PS it is obvious that communication is not everything and if the uptrend in inflation expectations is not resumed soon the BoJ should clearly signal a willingness to step up quantitative easing.

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Related post:
Mr. Kuroda’s credibility breakdown
Mr. Kuroda please ‘peg’ inflation expectations to 2% now
A few words that would help Kuroda hit his target

Japan’s widening trade deficit

Remember my earlier comment on monetary easing in Japan and the possible impact on the Japanese trade balance:

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.

Today we got data that seems to support my view that monetary easing in Japan is likely to widen the trade deficit. This is from AP:

Japan’s trade deficit rose nearly 10 percent in May to 993.9 billion yen (nearly $10.5 billion) as rising costs for imports due to the cheaper yen matched a rebound in exports, the Ministry of Finance reported Wednesday.

Exports rose 10.1 percent in May over a year earlier to 5.77 trillion yen ($60.7 billion) while imports also surged 10 percent, to 6.76 trillion yen ($71.1 billion), the ministry said. Japan’s trade deficit in May 2012 was 907.93 billion yen.

Hence, just looking at the trend in the trade deficit – it is widening – it would be tempting to declare victory on my hypothesis that the “Kuroda boom” mostly will be about domestic demand. However, I must admit that a lot of the reason for the increase in imports is higher energy imports. So while I do think my view is correct I don’t think that trade data in itself provides a lot support for this view.

HT Yichuan Wang

Mr. Kuroda’s credibility breakdown

This morning the Nikkei index has dropped has much as 6%. By any measure this is an extreme drop in stock prices in one day. Furthermore, we are now officially in bear market territory as the Nikkei is down more than 20% in just three weeks. I can only see one reason for this and one reason only and that is the breakdown of the credibility of Bank of Japan governor Kuroda and his commitment to fulfill his official 2% inflation target.

I would particularly highlight three events for this breakdown of credibility.

First of all I would stress that it seems like the Japanese government has been taken by surprise by the natural increase in bond yields and that is causing officials to question the course of monetary policy. This is Economy Minister Akira Amari commenting on the increase in bond yields on May 19:

“We need to enhance the credibility of government bonds to prevent a rise in long-term yields.”

This at least indirectly indicates that some Japanese government officials are questioning what the BoJ has been doing and given the highly political nature of the Japanese monetary policy setting these comments effectively could make investors question the direction of monetary policy in Japan.

Second the Minutes from Bank of Japan’s Policy board meeting on April 27 released On May 26 and comments following this week’s monetary policy meeting.

This is from the May 26 Minutes (quoted from MarketWatch):

“Regarding the effects of JGB purchases on liquidity in the JGB and repo market, a few members … expressed the opinion that it should continue to deliberate on measures to prevent a decline in liquidity”

Said in another way some BoJ board members would like the BoJ to try to keep bond yields from rising – hence responding to Mr. Amari’s fears. There is fundamentally only one way of doing this – abandoning the commitment to hit 2% inflation in two years. You can simply not have both – higher inflation and at the same time no increase in bond yields. Bond yields in Japan have been rising exactly because Mr. Kuroda has been successful in initially pushing up inflation expectations. It is that simple.

And third, at the BoJ’s monetary policy announcement this week Bank of Japan governor Kuroda failed to clarify the position of the BoJ and that undoubtedly has unnerved investors further.

5-year-inflation-expectations-japan

Hence, it is important that market turmoil does not reflect a fear of higher nominal bond yields on its own, but rather whether higher bond yields will cause the BoJ to abandon the commitment to increase inflation to 2%.

Therefore what is happening is a completely rational reaction from investors that rightly or wrongly fear that the BoJ is changing course.

As I again and again has stressed Mr. Kuroda can end the market turmoil by first of all stating that the increase nominal bond yields is no worry at all (particularly as real bond yields actually have dropped sharply) and furthermore he should clearly state that the BoJ’s focus is on inflation expectations. Hence, he should state that the BoJ effectively is ‘pegging’ market (breakeven) inflation expectations to 2%. If he did that he would effectively have hindered inflation expectations dropping over the past three weeks. The drop in Japanese inflation expectations in my view is the main cause of the turmoil in global financial markets over the past three weeks.

Should we give Mr. Kuroda a break?

I might be too harsh to Mr. Kuroda here. After all should we really expect everything to be ‘perfect’ at this early stage in the change to the monetary policy regime Japan after 15 years of failure?

This is the alway insightful Mikio Kumada commenting on Linkedin on one of my earlier posts on Japan:

“Lars, give it some time. The regime change at the BOJ is still very new and the ideological shifts in old conservative institutions, with long traditions, such as the BOJ take some time. I think Kuroda made it implicitly clear enough that higher nominal rates are ok as long as real interest rates slump/stay low.”

I think Mikio (who like a lot of market participants, central bankers and monetary policy nerds have join the Global Monetary Policy Network on Linkedin) is on to something here.

We are seeing a revolution at the BoJ so one should not really be surprised that it is not all smoothing sailing. However, on the other hand I am personally very doubtful where we are going next. Will Kuroda effectively be forced by events to abondon his commitment to 2% inflation or will he reaffirm that by becoming much more clear in his communication (don’t worry about higher nominal bond yields and communicate clearly in terms of inflation expectations).

I have my hopes, but I don’t know the answer to this question, but one thing seems clear and that is that nearly everything in the global financial markets – from the value of the South Africa rand, commodity prices and the sentiment in the US stock markets – these days dependent on what Mr. Kuroda does next. Don’t tell me that monetary policy is not important…

PS David Glasner is puzzled by what is going on the US financial markets. I think I just gave the answer above. It is not really Bernanke, but rather Mr. Kuroda David should focus on. At least this time around.

Confused central banks and the need for an autopilot

For somewhat more than a decade I have regularly been watching monetary policy decisions from different central banks around the world. Most ‘modern’ central banks in the world announce changes to monetary policy once every month. Mostly these events are pretty much none-events – the central banks do not surprise markets much. However, over the last fives years it has certainly been harder to predict the outcome of these meetings compared to how relatively easy it was in the decade before the crisis.

The reason it has become harder to predict central banks is that we are no longer on ‘autopilot’ in monetary policy. One we are unsure about ‘where we are going’ – the central banks’ monetary targets have become less clear – and in some case the target has even changed. Second, especially central banks where interest rates have dropped to close to zero are unsure about what instruments to use in the conduct of monetary policy.

This uncertainty has created more volatility in financial markets as the markets have a very hard time “reading” the central banks. The monetary policy decision from the Bank of Japan this morning is instructive.

Yesterday the Nikkei was up around 5%, but this morning the market has been slightly nervous ahead of the monetary policy announcement. However, after the announcement Nikkei initially dropped 1.5% on ‘disappointment’ (as it is said in the financial media) that the Bank of Japan did not introduce new measure to curb ‘bond market volatility’.

This is really rather bizarre. Central banks really shouldn’t run around and announce new initiatives and new monetary policy instruments every other month. Unfortunately we look at the major central banks such as the Federal Reserve, the ECB and Bank of England these banks over the past five years again and again have introduced new policy instruments. A lot of these instruments have not even been aimed at changing monetary conditions (changing the money base and/or expectations of future changes to the money base), but have been credit policies.

Ideally central banks should not even need to hold these monthly monetary policy meetings. If the central bank clearly defines its monetary policy target and define what primary instrument it is using to change monetary conditions then monetary policy to a large extent would be on autopilot. 

Try to target one target and no more than that

First of all the central banks of the world should make it complete clear what they are trying to achieve. What is the central bank targeting?

Second, the central banks should make it clear that it is targeting future value rather than present value of these variables – be it inflation, the price level or nominal GDP. Therefore, central banks should communicate about the expectation for these targets.

For inflation targeting central banks like the Bank of Japan the central bank is lucky has it actually have market expectations for future inflation. Hence, there is no reason for the Bank of Japan to even comment on present inflation. The only thing, which is important, is market expectations. If market expectations for future Japanese inflation is below the BoJ’s 2% inflation target then the BoJ will have to conclude that monetary conditions still are too tight. It can of course easily do something about that – it can just announce that it will continue to escalate the growth of the money base until the market is pricing in 2% future inflation. Remember there are no limits to the central bank’s ability to print money. The term that the central bank should keep the powder dry therefore is also idiotic. The central bank will never run out of gun powder.

Third, central banks should stop confusing themselves and the markets by pursuing more than one target. Essentially the central bank only has one monetary policy instrument – and that is the money base. Hence, the central bank can only hit one nominal target. One would think that this should be obvious, but unfortunately it is not.

Lets take the example of the Polish central bank (NBP). Last week the NBP cut its key policy interest rates by 25bp – effectively trying to boost the growth of the money base. Within days after that decision the same Polish central bank intervened in the currency market to strengthen the zloty. Hence, the NBP was selling foreign currency and buying zloty. Said, in another way the NBP tried to reduce the money base. Are you confused? It seems like the NBP is.

Unfortunately the NBP is not the only central bank in the world, which is confused about its own policies. The recent increased volatility in the Japanese markets is exactly a result of a similar kind of policy maker confusion.  In April the BoJ moved decisively to ease monetary policy. This was seen as a credible and permanent expansion of the money base. Not surprisingly this sparked a rally in the Japanese stock market, weakened the yen and have push up nominal bond yields. Market Monetarists were not surprised. Higher bond yields reflect higher growth and inflation expectations.

However, the BoJ seems to have been surprised by the impact of its own actions – particularly the increase in bond yields have made policy makers nervous. This led both BoJ and government officials to make unclear statements about the connection between bond yields and monetary policy. However, it is clear that if the BoJ in somewhat tries to target the level of bond yields it cannot also target inflation.

A similar problematic tendency of central bankers these days is an aversion against using certain policy instruments. Hence, central bankers have a preference to conduct monetary policy through interest rate changes. However, if the interest rate is close to zero then other instruments have to be used – for example directly expanding the money base.

However, it is very clear that for example a lot of Federal Reserve officials can’t wait to reduce the US money base. Logically that obviously makes no sense as it basically mean that the policy instrument enters on both the left-hand and the right-hand side of the central bank’s reaction function. The fed should obviously not reduce the money base before it is clear that it will hit its – not too well-defined – target.

The textbook advice to central banks therefore must be to target one nominal variable and target the market expectation of the future value of this variable.

Let the markets be the autopilot for monetary policy  

If the central bank formulates its target in the form of expectations then it is really very simple to introduce an autopilot monetary policy.

Again lets take the example of the Bank of Japan. The BoJ is now officially targeting inflation at 2%. It wants to achieve that target in two-years.

The market obviously provides a measure of how likely the BoJ is to meet this target in the form of breakeven inflation expectations from inflation-linked Japanese government bonds. The verdict from the market is clear – while inflation expectations have risen significantly the market is still far from pricing in 2% inflation.

In fact 2-year/2-year inflation expectations – that is the market expectations for inflation two years from now and two years ahead – is closer to 1% than to 2%.

So while the BoJ has credibly eased monetary policy its inflation target is still far from credible.

The easiest way to make that target credible is simply to announce that market expectations for Japanese inflation should be 2%. Or as I have suggested before the BoJ should simply ‘peg’ the inflation expectation to 2%. It should announce that if inflation expectations are below 2% when the BoJ will simply buy inflation linked bonds until inflation expectations hit 2% and similarly of course sell inflation-linked bonds if inflation expectations move above 2%.

In that scenario Japanese monetary policy would be completely on autopilot. The BoJ would not have to confuse itself and markets by introducing instruments every months or by giving cryptic statements about the state of the Japanese economy.

The BoJ could simply monthly report on the markets’ inflation expectations. If that BoJ did that then this months’ monetary policy statement would look something like this:

“The Bank of Japan is targeting 2% inflation. Market expectations for inflation on all relevant time horizons shows that inflation expectations have increased over the past year. Unfortunately inflation expectations are still significantly below 2% and as such the 2% inflation target is no yet fully credible.

However, the Bank of Japan has the full control of the Japanese monetary base and is ready to expand the money base as much as needed to bring inflation expectations fully in line with the inflation target. Hence, the Bank of Japan will continue to step up the buying of inflation-linked government bonds until there is full correspondence between the inflation target and market expectations.”

If I were a market participant that read that statement I would start buying inflation-linked bond immediately – and I would sell the yen and buy some more Japanese equities. And I am sure we very fast would see the market price in 2% inflation. Mission accomplished.

And once inflation expectations have been ‘pegged’ to 2% the BoJ could simply put the following text on it website: “Bank of Japan targets 2% inflation. Inflation expectations are at 2%. Monetary policy is 100% credible. We have gone golfing”.

I am writing this on a flight to Brussels (so I am not on the internet) while BoJ governor Kuroda is having a press conference. I very much hope he will be saying something similar to what I have suggested, but I am not overly optimistic.  

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Update: A quick glance through Kuroda’s comments indicates that he doesn’t really get it. He talks about controlling bond market volatility and makes some but not too impressive comments on breakeven inflation rates. It is sending stock markets down around the world. (By the way if Japanese monetary easing is part of an evil ‘currency war’ why are global stock markets falling when the BoJ fails to deliver?) 

A few words that would help Kuroda hit his target

The developments in the Japanese financial markets over the past week has caused a lot of debate about the sustainability of the “Kuroda shock”. It is particularly the rise in nominal bond yields, which seems to have shaken some Japanese policy makers.

Even though the rise in nominal bond yields is a completely expected (for Market Monetarists) and welcomed (!) result of monetary easing it has nonetheless caused some to suggest that Kuroda’s monetary regime change is self-defeating.

As I have explained earlier the increase in bond yields in itself is not a threat to the recovery, but I must also admit that some Japanese policy makers (and a lot of commentators) have a hard time understanding this. It might therefore be warranted that Bank of Japan chief Kuroda puts the record straight.

He can do this by again and again repeating the following statement:

“The increase in Japanese nominal government bond yields is welcomed news as it reflects investors’ expectations for higher nominal spending growth. Furthermore, I am very happy to see that real bond yields continue to decline as markets are pricing in that we are increasingly likely to hit our 2% inflation target.

However, I am not satisfied with the speed of adjustment of market expectations to our inflation target. When we say we have a 2% inflation target investors should listen.

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.”

Anybody who have been reading my blog (and Robert Hetzel!) should understand why the reference to break-even inflation expectations is extremely important…

Mr. Kuroda, the advise is for free. Please take it.

Japan badly needs structural reforms, but not more than the rest of the G7 countries

A key critique of monetary easing in Japan is that Japan’s real problem is not monetary, but rather a supply side problem. I strongly agree that the Japanese economy is facing serious structural challenges – particularly an old-age population and a declining labour force. However, I also think that there often is a tendency for commentators to overstate these problems compared to supply side problems in other developed economies.

In this post I will therefore try to compare Japan’s structural problems with the structural problems of the other G7 economies – the US, UK, Canada, Germany, France and Italy.

The conservative US think tank Heritage Foundation every year produces an Economic Freedom Index. Even though one certainly can discuss the methods used to calculate this index I overall believe that the Index gives a pretty good description of the level of economic liberalization in difference countries. And yes, I do equate the level of economic liberalization with less structural problems.

The graph below shows the ranking of the G7 countries in the 2013 Index of Economic Freedom.

Economic Freedom Index G7

The picture is pretty clear. The Anglo-Saxon countries Canada (6), USA (10) and the UK (14) are significantly more economically free than particularly the interventionist South European countries France (62) and Italy (83).

Japan (24) shares the “median” position with the other large exporter in the group – Germany (19).

So while there certainly is scope for reforms in Japan it is hard to argue that Japan in general is a lot more interventionist than the other large economies of the world.

In fact it is also hard to argue that Japan has performed worse than the other G7 countries over the past decade. As the graph below shows Japanese GDP/capita has grown more or less in line with the other G7 countries since 2001-3. The real underperformer is Italy rather than Japan, which should not be surprising given Italy’s interventionist policies and excessive regulation.

A closer look at Japan’s structural weaknesses

But lets have a closer look at the data and see what Japan’s structural problems really are.

The graph below shows Japan’s relative ranking among the G7 economies in each of the subcategories of Index of Economic Freedom. I have indexed the average G7 ranking for each category at 100. The higher a score the more “free”.

Economic Freedom Japan 2Again the story is the same – Japan falls smack in the middle among the G7 countries when it comes to economic freedom – with an average for all the categories score of 101.

The breakdown of the numbers reveals both Japan’s relative strengths and weaknesses.

For example the Japanese public sector is relative small compared to the average of the other G7 countries and the Japan’s labour market is relatively free.

However, it is also clear that there are some clear regulatory weaknesses. This is particularly the case in the areas of trade, business, investment and financial freedom.

The three first of them all really is about an overly protectionist Japanese economy – both when it comes to foreign and domestic investors and I think it is pretty obvious that this is where the reform effort in Japan should be focused.

Mr. Abe please open up the Japanese economy

I really think it is straight forward. If Prime Minister Abe seriously wants to reform his country’s economy he needs to open it up to competition – both domestic and foreign.

In the domestic economy I would like other commentators highlight the lack of competition in the retail sector where for example the  “Large Scale Retail Location Law” tend to give artificial protection to small retail outlets (mom-and-pop shops) rather than bigger and more efficient retail shops such as hypermarkets.

Similarly zoning laws are hindering competition in the retail sector while at the same time is deepening the decade long Japanese property market crisis.

Finally I would note that interventionism in the agricultural sector in Japan is at least as bad as in the EU with price controls and very high levels of subsidies. Just see these scary facts from a recent WSJ article:

“In 2010, farmers added 4.6 trillion yen ($45 billion) in value and consumed 4.6 trillion yen in subsidies, meaning the industry netted out to zero. The average Japanese farmer is 66 years old and tills 1.9 hectares of land.”

This is hardly an efficient use of economic resources. The need for retail, housing and agricultural reforms therefor for seem to be very clear and this is where the focus should be for Mr. Abe when he fires off what he has called his “Third arrow” – structural reform.

Trade and investment liberalization will could enhance global support for Abenomics

Bank of Japan’s efforts to ease monetary policy has been criticized for being a beggar-they-neighbour policy. I think is a completely misplaced critique, however, it is indisputable that the outside world increasingly think of Japan as protectionist. I believe that a good way to calm these fears would be for the Japanese government to unilaterally remove all trade barriers and trade tariffs as well as opening up the Japanese economy to foreign investments. That would be in the best interest of the Japanese economy and would significantly boost Japanese productivity, while at the same making it very hard to the outside world to argue that Japan is protectionist.

The focus on monetary reform as been right and will support structural reforms

Even though there is an urgent need for economic reforms in Japan I fundamentally don’t think that the need for economic reforms is bigger than in France or Italy or even in Germany and I therefore think that the focus on monetary reform has been correct.

Furthermore, as the new monetary policy regime is likely to pull Japan out of deflation and boost economic growth (in the next 2-3 years) the Abe government is likely to get more support for implementing less popular reforms. Furthermore, as the new monetary policy regime is very likely to increase nominal GDP growth both public finance and banking problems are likely to be reduced, which in itself is likely to support real GDP growth over the longer run.

Concluding, the Abe government has gotten it more or less right on monetary regime (even though I would have preferred NGDP targeting to inflation targeting) and it is now time for Prime Minister Abe to prepare for his Third Arrow.

Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)

I have no doubt that Milton Friedman would have congratulated Bank of Japan governor Haruhiko Kuroda on the fact that Japanese bond yields continue to rise.

This is what Friedman said about the level of bond yields and interest rates in 1998:

“Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.”

Lets take it again – “As the economy revives, however, interest rates would start to rise”. Hence, the fact the Japanese bond yields are rising – and have done so since he presented his monetary policy regime change in early April – is a very clear sign that Mr. Kuroda’s efforts to get Japan out of deflation is working.

However, not all agree. This is  in the Telegraph quoting Richard Koo (Ambrose as we know do not agree with Koo):

“Richard Koo…an expert on Japan’s Lost Decade, said the sell-off in recent days has shown that the BoJ may not be able to hold down yields “no matter how many bonds it buys”. This could lead to a “loss of faith in the Japanese government” and the “beginning of the end” for its economy, if handled badly.”

Richard Koo obviously do not understand the monetary transmission mechanism. The purpose of what the Bank of Japan is doing is not to keep bond yields down. The purpose is to increase the money base and increase inflation expectations (to 2%). Both things are of course happening and the markets have not lost faith in the Japanese government or the Bank of Japan. Rather the opposite is the case.

Yes, nominal bond yields are rising – as Friedman and every living Market Monetarist said they would. However, real bond yields have collapsed since the introduction of Japan’s new monetary regime as inflation expectations have picked up. Something Mr. Koo for years has denied the Bank of Japan would be able to do.

Furthermore – and much more important – the markets do not think that the Japanese government is about to go bankrupt. In fact completely in parallel with the increase in inflation expectations the markets’ perception of the Japanese government’s default risk have decreased. Hence, the 5-year Credit Default Swap on Japanese companies has dropped from around 225bp in October last year to around 70bp today and at the same time the CDS on the government of Japan has declined as well – albeit less so.

This is actually not surprising at all. As monetary policy has been eased the expectation for nominal GDP growth has accelerated and as a natural consequence the markets are also starting to price in that the debt-to-NGDP ratio will drop. This is simple arithmetics.

Hence, the markets today feels significantly more comfortable that Japan will not default than was the case prior to Shinzo Abe and his Liberal Democratic Party won the Japanese elections in September last year.

So it might be that Richard Koo is thinking that Abenomics is the “beginning of the end” for Japan, but I rather think that Abenomics might be the beginning of the end for Mr.Koo’s theory of the balance sheet recession in Japan.

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Nick Rowe has a blog post on the same topic.

Update: Scott Sumner basically put out the same post as me at the same time (at least the headlines are very similar). Scott, however, is slightly less optimistic about Abenomics than I am.

Update 2: And here is Marcus Nunes on a similar topic (why Richard Koo is wrong).

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.

Bennett McCallum told “my” Kuroda story a decade ago

From to time I will make an argument and then later realize that it really wasn’t my own independently thought out argument, but rather a “reproduction” of something I once read. Often it would be Milton Friedman who has been my inspiration, however, Friedman is certainly not my only inspiration.

Another economist who undoubtedly have had quite a bit of an influence on my thinking is Bennett McCallum and guess what – it turns out that the argument that I was making in my latest post on the “Kuroda recovery” is very similar to the type of argument Bennett made in a number of papers around a decade ago about how to get Japan out of the deflationary trap. Bennett has kindly pointed this out to me. I know Bennett’s work on Japan quite well, but when I was writing my post yesterday I didn’t realize how close my thinking was to Bennett’s arguments.

I therefore think it is appropriate to touch on some of Bennett’s main conclusions and how they relate to the situation in Japan today.

I my previous post I argued that easing of monetary policy in Japan would primarily work through an increase in domestic demand – contrary to the general perception that monetary easing would primarily boost exports through a depreciation of the yen. Bennett told the exact same story a decade ago in his paper “Japanese Monetary Policy, 1991–2001” (and a number of other papers).

While I used general historical observations to make my argument Bennett in his 2003 paper uses a formal model. His model is a variation of an open economy DSGE model calibrated for the Japanese economy originally developed with Edward Nelson.

In his paper Bennett simulates a shock to inflation expectations – from -1% inflation to +1% inflation. Hence, this is not very different from the actual shock we are presently seeing in Japan. However, while the “Kuroda-shock” is a direct shock to the money base in Bennett’s example the exchange rate is used as the policy instrument.  However, this is not really important for the results in the model (as far as I can see at least…).

In Bennett’s model the Bank of Japan is buying foreign assets to weaken the yen to increase inflation expectations. According to the general perception this should lead to an marked improvement Japanese net exports. However, take a look at what conclusion Bennett reaches:

The variable on whose response we shall focus is the home country’s— i.e., Japan’s—net export balance in real terms….we see that the upward jump in the target inflation rate (π), which occurs in period 1, does indeed induce an exchange-rate depreciation rate that remains positive for over two years. Inflation, not surprisingly, rises and stays above its initial value for over two years, then oscillates and settles down at a new steady state rate of 0.005 (in relation to its starting value). Quite surprisingly, p responds more strongly than s so the real exchange rate appreciates. As expected, however, real output rises strongly for two years.

Most importantly, the real (Japanese) export balance is so affected by the two-year increase in real output that it turns negative and stays negative for almost two years.

Hence, Bennett’s simulations shows the same result as i postulated in my previous post – that monetary easing even if it leads to a substantial weakening of the yen will primarily boost domestic demand. In fact it is likely that after a few quarters the boost to domestic demand will lead to higher import growth than export growth and hence the net impact on the Japanese trade balance is likely to be negative.

Said, in another way there is no beggar-thy-neighbor-effect. In fact is anything monetary easing in Japan is likely to boost exports to Japan rather than the opposite.

I am sure that Bennett’s papers also in the future will inspire me to write blog posts on different topics as anybody who follow my blog knows it has done in the past – even when I don’t realize myself to begin with. Until then I suggest to my readers that you take a look at Bennett’s 2003 paper. It will teach you quite a bit about what is happening in Japan a decade after Bennett wrote the paper.

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.

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