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?) 

Leave it to the market to decide on “tapering”

The rally in the global stock markets has clearly run into trouble in the last couple of weeks. Particularly the Nikkei has taken a beating, but also the US stock market has been under some pressure.

If one follows the financial media on a daily basis it is very clear that there is basically only one reason being mentioned for the decline in global stock markets – the possible scaling back of the Federal Reserve’s quantitative easing.

This is three example from the past 24 hours. First CNBC:

“Stocks posted sharp declines across the board Wednesday, with the Dow ending below 15,000, following weakness in overseas markets and amid concerns over when the Fed will start tapering its bond-buying program on the heels of several mixed economic reports.”

And this is from Bloomberg:

“U.S. stocks fell, sending the Standard & Poor’s 500 Index to a one-month low, as jobs and factory data missed estimates and investors speculated whether the Federal Reserve will taper bond purchases.”

And finally Barron’s:

“Fear that the central bank may start scaling back its $85 billion in monthly bond purchases has helped trigger a sharp increase in market volatility over the last couple of weeks both here and overseas.”

I believe that what we are seeing in the financial markets right now is telling us a lot about how the monetary transmission mechanism works. Market Monetarists say that money matters and markets matter. The point is that the markets are telling us a lot about the expectations for future monetary policy. This is of course also why Scott Sumner likes to say that monetary policy works with long and variable LEADS.

Hence, what we are seeing now is that US monetary conditions are being tightened even before the fed has scaled back asset purchases. What is at work is the Chuck Norris effect. It is the threat of “tapering” that causes US stock markets to decline. Said in another way Ben Bernanke has over the past two weeks effectively tightened monetary conditions. I am not sure that that was Bernanke’s intension, but that has nonetheless been the consequence of his (badly timed) communication.

This is also telling us that Market Monetarists are right when we say that both interest rates and money supply data are unreliable indicators of monetary conditions – at least when they are used on their own. Market indicators are much better indicators of monetary conditions.

Hence, when the US stock market drops, the dollar strengthens and implied market expectations of inflation decline it is a very clear signal that US monetary conditions are becoming tighter. And this is of course exactly what have happened over the last couple of weeks – ever since Bernanke started to talk about “tapering”. The Bernanke triggered the tightening, but the markets are implementing the tigthening.

Leave it to the market to decide when the we should have “tapering”

I think it is pretty fair to say that Market Monetarists are not happy about what we are seeing playing out at the moment in the US markets or the global markets for that matter. The reason is that we are now effectively getting monetary tightening. This is certainly premature monetary tightening – unemployment is still significantly above the fed’s unofficial 6.5% “target”, inflation is well-below the fed’s other unofficial target – 2% inflation – and NGDP growth and the level NGDP is massively below where we would like to see it.

It is therefore hardly the market’s perception of where the economy is relative to the fed’s targets that now leads markets to price in monetary tightening, but rather it is Bernanke’s message of possible “tapering” of assets purchases, which has caused the market reaction.

This I believe this very well illustrates three problems with the way the fed conducts monetary policy.

First of all, there is considerable uncertainty about what the fed is actually trying to target. We have an general idea that the fed probably in some form is following an Evans rule – wanting to continue to expand the money base at a given speed as long as US unemployment is above 6.5% and PCE core inflation is below 3%. But we are certainly not sure about that as the fed has never directly formulated its target.

Second, it is clear that the fed has a clear instrument preference – the fed is uncomfortable with conducting monetary policy by changing the growth rate of the money base and would prefer to return to a world where the primary monetary policy instrument is the fed funds target rate. This means that the fed is tempted to start “tapering” even before we are certain that the fed will succeed in hitting its target(s). Said, in another way the monetary policy instrument is both on the left hand and the right hand side of the fed’s reaction function. By the way this is exactly what Brad DeLong has suggested is the case. Brad at the same time argues that that means that the fiscal multiplier is positive. See my discussion of that here.

Third the fed’s policy remains extremely discretionary rather than being rule based. Hence, Bernanke’s sudden talk of “tapering” was a major surprise to the financial markets. This would not have been the case had the fed formulated a clear nominal target and explained its “reaction function” to markets.

Market Montarists of course has the solution to these problems. First of all the fed should clearly formulate a clear nominal target. We obviously would prefer an NGDP level target, but nearly any nominal target – inflation targeting, price level targeting or NGDP growth targeting – would be preferable to the present “target uncertainty”.

Second, the fed should leave it to the market to decide on when monetary policy should be tightened (or eased) and leave it to the market to actually implement monetary policy. In the “perfect world” the fed would target a given price for an NGDP-linked bond so the implied market expectation for future NGDP was in line with the targeted level of NGDP.

Less can, however, do it – the fed could simply leave forecasting to either the markets (policy futures and other forms of prediction markets) or it could conduct surveys of professional forecasters and make it clear that it will target these forecasts. This is Lars E. O. Svensson’s suggestion for “targeting the forecast” (with a Market Monetarist twist).

Concluding, the heightened volatility we have seen in the US stocks markets over the last two weeks is mostly the result of monetary policy failure – a failure to formulate a clear target, a failure to be clear on the policy instrument and a failure of making it clear how to implement monetary policy.

Bernanke don’t have to order the printing of more money. We don’t need more or less QE. What is needed is that Bernanke finally tells us what he is really targeting and then he should leave it to the market to implement monetary policy to hit that target.

PS I could have addressed this post to Bank of Japan and governor Kuroda as well. Kuroda is struggling with similar troubles as Bernanke. But he could start out by reading these two posts: “Mr. Kuroda please ‘peg’ inflation expectations to 2% now” and “A few words that would help Kuroda hit his target”. Kuroda should also take a look at what Marcus Nunes has to say.

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).

How to avoid a repeat of 1937 – lessons for both the fed and the BoJ

The Japanese stock market dropped more than 7% on Thursday and even though we are up 3% this morning there is no doubt that “something” had scared investors.

There are likely numerous reasons for the spike in risk aversion on Thursday, but one reason is probably that investors are getting concerned about the Federal Reserve and the Bank of Japan getting closer to scaling back monetary easing. That has reminded me on what happened in 1937 – when market participants panicked as they started to fear that the Federal Reserve would move prematurely towards monetary tightening – after the US economy had been in recovery since FDR took the US off the gold standard in 1933.

Going into 1937 both US government officials and the Fed officials started to voice concerns about inflationary pressures, which clearly sent a signal to market participants that monetary policy was about to be tightened. That caused the US stock market to slump and sent the US economy back into recession – the famous Recession in the Depression.

At the core of this policy mistake was the fact that the fed had never clearly defined and articulated a clear monetary policy target after going off the gold standard in 1933. The situation in many ways is similar today.

Market participants in general know that the fed is likely to scale back monetary easing when the US economy “improves”, but there is considerable uncertainties about what that means and the fed still has not clearly articulated its target(s). Furthermore, the fed continues to be very unclear about its monetary policy instruments. Hence, the fed still considers the fed fund target rate as its primary monetary policy instrument while at the same time doing quantitative easing.

These uncertainties in my view certainly make for a much less smooth ‘transition’ in monetary policy conditions in the US. Therefore, instead of focusing on when to scale back “QE” the fed should focus 100% on explaining its target so nobody is in doubt about what the fed really is targeting. Furthermore, the fed needs to stop thinking and communicating about monetary policy in terms of interest rates. The money base and not the interest rate is the key monetary policy instrument in the US and it is about time that the fed acknowledges this.

How about trying the “perfect world”

The best way of getting rid of these monetary policy uncertainties is for the fed to first of all give an explicit nominal target. Preferably the fed should simply state that it will conduct monetary policy in a way to increase nominal GDP by 15% in the coming two years and thereafter target 5% annual NGDP growth (level targeting).

Second, the fed then should become completely clear about its monetary policy. The best thing would be a futures based NGDP targeting. See here for a description about how that would work. Alternatively the fed should clearly spell out a ‘reaction function’ and clearly describe its monetary policy instrument – what assets will the fed buy to expand or contract the money base? It is really simple, but so far the fed has totally failed to do so.

Japanese monetary policy has become a lot clearer after Haruhiko Kuroda has become Bank of Japan chief, but even the BoJ needs to work on its communication policy. Why is the BoJ not just announcing that since it now officially has a 2% inflation target it will ‘peg’ the market expectations for example for 2-year or 5 year (or both) inflation at 2% – and hence simply announce a commitment to sell or buy inflation-linked bonds so the implicit breakeven inflation is 2% on all time horizons at any period in time. This is of course a set-up Bob Hetzel long ago suggested for the fed. Maybe it is time the BoJ invited Bob back to for a visit in Japan?

If the fed and the BoJ in this fashion could greatly increased monetary policy transparency the markets would not be left guessing about what they central banks are targeting or about whether there will be a sudden redrawl of monetary policy accommodation.  Thereby it could be ensured that the scaling back of monetary easing will happen in a disorderly fashion. There is not reason why we need repeating the mistakes of 1937.

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Both David Glasner and Marcus Nunes have related posts.

See also here if you want to read what I wrote about the Japanese “jitters” yesterday in my day-job.

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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