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

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

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

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

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

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

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

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

Prime Minister Abe is repeating Roosevelt’s mistakes   

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

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

This is from Bloomberg today:

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

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

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

Abe wage shock

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

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

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

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

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

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

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

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

All we need is the AS-AD framework

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

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

The graph below is our starting point.

AS AD

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

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

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

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

inflation target BoJ ASAD

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

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

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

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

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

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

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

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

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

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

A golden opportunity for the BoJ to increase credibility

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

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

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

And further it says:

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

And finally:

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

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

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

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

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

Mr. Kuroda’s vacation plans

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

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

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

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

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

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

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

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

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

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

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

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

Lack of credibility shortens Mr. Kuroda’s vacation

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

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

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

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

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

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

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

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

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

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This blog post is also available in Japanese here.

Unfocused vacation musings on money – part 1

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

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

Egyptian Regime Uncertainty

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

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

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

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

A Polish deflationary monetary policy blunder

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

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

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

A confident Kuroda should not be complacent

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

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

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

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

Summertime reading…

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

Vacation books

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

Let me say it again – it’s domestic demand (in Japan), stupid

The Nikkei had a 20% set-back, but is now surely making a major comeback. This morning Nikkei is up 3.5%. The rally continues supported by very strong macroeconomic numbers and you have to be very suborn to continue to claim that monetary easing is not working in Japan (I wonder what Richard Koo will be saying…)

I think the most notable thing about the Japanese economy right now is that it is domestic demand rather than exports, which is really the driver of growth. This is of course what I have argued all along (see my earlier comments here, here, here and here).

But let me instead quote my good colleague and Danske Bank’s Asia analyst Flemming Nielsen:

“Data released overnight shows that the Japanese economy continues to power ahead and now appears to be moving out of deflation. While Japan’s export so far is urprisingly resilient, it would be wrong to accuse Japan of just stealing growth from the rest of the world through a weaker yen. On the contrary the Japanese economy currently appears to be gaining much of its strength from strong domestic demand.

Despite all the focus on the negative impact from a weaker yen, Japan at the moment appears to be a stabilizing force for the global economy. The data released overnight indicates GDP growth above 3.5% q/q AR in Q2 on the back of 4.1% q/q growth in Q1.

…Japan’s industrial production continued to expand solidly in May, where industrial production seasonal adjusted increased 2.0% m/m. This was much stronger than expected and the fourth month in a row with an increase. The strength in manufacturing activity was also evident in the Markit/JMMA manufacturing PMI for June, where it improved to 52.3 from 51.5 in May …The export orders component did decrease slightly from 52.1 from 52.6 but overall was surprisingly resilient. Total new orders continued to improve to 54.7 in June from 53.7 in May underscoring the current importance of strong domestic demand for the recovery in Japan.

…Deflation continued to ease in May where CPI excl. fresh food (the inflation measure BoJ targets) increased 0.0% y/y after declining 0.4% y/y in April. Core CPI excl. food & energy declined 0.3% y/y after declining 0.6% y/y in April. Based on preliminary CPI date for June for the Tokyo area we estimate that nationwide CPI excl. fresh food will stay at 0.0% y/y in June but CPI should start to show a positive year-on-year increase during Q3.

I find it very hard to be pessimistic about the Japanese story – monetary policy is working exactly the way Market Monetarists have argued it would work. The Bank of Japan is ending 15 years of deflation and in the process the Japanese economy is taking off. Imagine that the ECB would dare do something similar?

PS Yes, Kuroda still needs to work on communication and yes Japan badly needs structural reforms, but that is not changing that monetary policy is working.

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

Chinese monetary policy failure

“Fed tapering” seems to be repeated in every single story in the financial media over the last couple of days. However, I am afraid that the financial media – as often is the case – is overly US centric. We might want to look at another central bank than the Fed. We should instead pay some (a lot!) of attention to the People’s Bank of China (PBoC).

This is from CNBC:

“China’s central bank continued to test the resilience of local lenders to withstand a cash crunch on Thursday, as money market rates soared once again and short-term rates hit record highs.

The seven-day repo rate, which is seen as gauge of confidence to lend in the interbank market, rose to a record high above 10 percent. China’s overnight repo rate jumped to as high as 30 percent, analysts said.

Chinese money markets have suffered a severe liquidity strain in the past week, due to seasonal factors and a sharp slowdown in foreign exchange inflows, raising concerns about the financial risks facing the world’s second largest economy.

But to the surprise of many market participants, the central bank has held back from pumping cash into the market to ease the credit squeeze and analysts said a spike in the rates at which banks lend money to each other was also a concern. “

I can’t help thinking that we have seen this before. The fed and ECB actions in 2008 come to mind.

This is what I said in my post “Dangerous bubbles fears” in October last year:

“…the PBoC eased monetary policy aggressively in 2009 and that pulled the Chinese economy out of the crisis very fast, but since 2010 the PBoC obviously has become fearful that it had created a bubble – which is probably did. To me Chinese monetary policy probably became excessively easy in early 2010 so it was right to scale back on monetary easing, but money supply growth has slowed very dramatically in the last two years and monetary policy now seem to have become excessively tight.”

It seems to me that the PBoC is just continuing the excessive tightening and that seems to be the real culprit behind the stream of bad economic data we have got out of China recently. It looks like Chinese monetary policy failure.

So yes, Bernanke might have a communication problem, but at the moment it seems like the biggest monetary policy failure is Chinese rather than American.

PS it seems like the Bank of Japan is regaining some credibility – the Nikkei has been remarkably resilient in recent days.

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

If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING

Among ‘internet Austrians’ there is an idea that there is gigantic bubble in the global bond markets and when this bubble bursts then the world will come to an end (again…).

The people who have these ideas are mostly people who never really studied any economics and who get most of their views on economics from reading more or less conspiratorial “Austrian” school websites. Just try to ask them and they will tell you they never have read any economic textbooks and most of them did not even read Austrian classics as “Human Action”. So in that sense why should we worry about these views?

And why blog about it? Well, because it is not only internet Austrians who have these ideas. Unfortunately many central bankers seem to have the same kind of views.

Just have a look at this from the the Guardian:

A key Bank of England policymaker has warned of the risks to global financial stability when “the biggest bond bubble in history” bursts.

In a wide-ranging testimony to MPs, Andy Haldane, Bank of England director of financial stability, admitted the central bank’s new financial policy committee is taking too long to force banks to hold more capital and appeared to criticise the bank’s culture under outgoing governor Sir Mervyn King.Haldane told the Treasury select committee that the bursting of the bond bubble – created by central banks forcing down bond yields by pumping electronic money into the economy – was a risk “I feel acutely right now”.

He also said banks have now put the threat of cyber attacks on the top of their the worry-list, replacing the long-running eurozone crisis.

“You can see why the financial sector would be a particularly good target for someone wanting to wreak havoc through the cyber route,” Haldane said.

But he described bond markets as the main risk to financial stability. “If I were to single out what for me would be biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally.” he said. There had been “shades of that” in recent weeks as government bond yields have edged higher amid talk that central banks, particularly the US Federal Reserve, will start to reduce its stimulus.

“Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history,” Haldane said. “We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted.”

I must admit that I am somewhat shocked by Haldane’s comments as it seems like Haldane actually thinks that monetary easing is the cause that global bond yields are low. The Bank of England later said it was not the view of the BoE, but Haldane’s “personal” views.

If Haldane ever studied Milton Friedman it did not have an lasting impact on his thinking. Milton Friedman of course told us that low bond yields is not an result of easy monetary policy, but rather a result of excessively TIGHT monetary policy. Hence, if monetary conditions are tight then inflation and growth expectations are low and as a consequence bond yields will also be low.

Hence, Milton Friedman would not be surprised that Japanese and US bond yields have risen recently on the back of monetary easing being implemented in the US and Japan.

In fact the development in global fixed income markets over the past five years is a very strong illustration that Friedman was right – and why Haldane’s fears are misguided. Just take a look at the graph below – it is 10-year US Treasury bond yields.

10y UST

(If you think you saw this graph before then you are right – you saw it here).

If Haldane is right then we should have seen bond yields decrease following the announcement of monetary easing. However, the graph shows that the opposite have happened.

Hence, the announcement of TAP and the dollar swaps lines in early 2009 was followed by an significant INCREASE in US (and global) bond yields. Similarly the pre-announcement of ‘QE2’ in August 2010 also led to an increase in bond yields.

And finally the latest sell-off in the global fixed income markets have coincided with monetary easing from the fed (the Evans rule) and the Bank of Japan (‘Abenomics’)

If you think there is a bond bubble

then blame the ECB’s rate hikes in 2011

Looking at US 10-year yields over the past five years we have had three major “down-legs”. The first down-leg followed the collapse of Lehman Brothers in October 2008. The second down-leg played out in the first half of 2010 following the hike in Federal Reserve’s discount rate in February 2010 and the People Bank of China’s increase in the reserve requirement in January 2010.

However, the biggest down-leg in US 10-year bond  yields followed the ECB’s two rate hikes of 2011 (April and July). Believe it or not, but the ECB was “able” to reduce US 10-bond yields more than the collapse of Lehman Brothers did.

Hence, if there is a ‘bubble’ in the global fixed income markets it has not been caused by monetary easing. No if anything it is a result of excessively tight monetary conditions.

In fact it is completely absurd to think that global bond yields are low as a result of central bank ‘manipulation’. Global bond yields are low because investors and households fear for the future – fears of low growth and deflationary tendencies. Global bond yields are low because monetary policy have been excessive tight.

Rejoice! Yields are rising

Unlike Andy Haldane I do not fear that day the bond ‘bubble’ (it is not a bubble!) will burst. In fact I look forward to the day US bond yields (and UK bond yields for that matter) once again are back to 5%. Because that would mean that investors and households again would believe that we are not heading for deflation and would once again believe that we could have ‘normal’ GDP growth.

And unlike Haldane I don’t believe that higher bond yields would lead to financial armageddon and I don’t believe that Japan will default if Japanese bond yield where to rise to 3 or 4%. Banks and countries do not go belly up when growth takes off. In fact the day US bond yields once again is back around 5% we can safely conclude that the Great Recession has come to an end.

Concluding, there is no ‘bond bubble’ and Andy Haldane should not have sleepless nights over it. The Bank of England did not cause UK yields to drop – or rather maybe it did, but only because monetary policy has been too tight rather than too easy.

PS I never heard any of these ‘bubble mongers’ explain why Japanese property prices and equity prices have been trending downward for nearly two decades despite interest rates being basically at zero in Japan.

PPS the graph above also shows that “Operation Twist” in 2011 failed to increase growth and inflation expectations. Any Market Monetarists would of course have told you that “Operation Twist” would fail as it did nothing to increase the money base or increase the expectation for future money base expansion.

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Related posts:

When US 30-year yields hit 5% the Great Recession will be over
Confused central banks and the need for an autopilot
Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)
Tight money = low yields – also during the Great Recession

‘Bullish Mikio’ makes me optimistic on BoJ (and the world)

As my loyal readers would know I have been somewhat critical about the Bank of Japan’s handling of the recent rise in bond yields in Japan. See for example here and here.

However, there is no reason to give up on the Bank of Japan. At least that is what the always clever Mikio Kumada is telling us. This Mikio’s excellent comment on my latest comment on the BoJ.

“Just wanted to say that in substance, I share your concerns. And I think it’s important that you raise these questions/criticisms.

I am, however, perhaps, less ideological, and try to look at things in the context of the real world.
Policy makers act in a political/institutional framework, with constraints. And in that context, the BoJ under Kuroda is dong a good job – as good as it gets, so to speak, from a market monetarist perspective.

By the way, yesterday, Kuroda met Abe and both made statements afterwards. Neither of them mentioned the need to keep interest rates low. They said all the other things – Kuroda reaffirmed he will beat deflation and Abe said he will do his part via reforms, but they didn’t make statements about interest rates.

That is another indication that Kuroda believes that higher nominal rates are desirable, and logical. And he may have convinced Abe not to talk about “lowering interest rates” (if Abe needed any convincing). But at the same time, Kuroda can’t yet openly that say he wants rising nominal rates.

My sense is that Kuroda, and also Prof. Koichi Hamada, a trusted advisor to Abe, are open to market monetarist ideas. But they would probably face a hailstorm if they openly say things that are too “revolutionary”. They first have to convince enough people that rising nominal yields are good, as long as real yields (and real wages) remain low, or keep falling during the “reflation” phase. But I would not recommend Abe to talk too much about “falling real wages” publicly ahead of an election, of course. He should just stick to demanding rising (nominal) wages.

I also sense that yesterday’s decline in stocks may have been due to (an erroneous) “disappointment” of investors that Abe/Kuroda didn’t say they want low/lower long term rates.

So, overall, I remain quite optimistic that, over time, the market will come around to accept the view that higher nominal rates are a good thing.”

I find it hard to disagree with Mikio’s comments. So I am starting the weekend being quite optimistic that the BoJ eventually will get it right and if Mikio indeed is right then the market turmoil we have seen over the last couple of weeks will soon come to an end. Fingers crossed.

PS Joseph Gagnon has an excellent comment on the BoJ and the need for not stepping back on monetary easing.

Join the Global Monetary Policy Network on Linkedin here (Mikio is a member).

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