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.


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).

Tight money = low yields – also during the Great Recession

Anybody who ever read anything Milton Friedman said about monetary policy should know that low interest rates and bond yields mean that monetary policy is tight rather than easy. And when bond yields drop it is normally a sign that monetary policy is becoming tighter rather than easier.

Here is Friedman on what he called the interest rate fallacy in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Unfortunately the old fallacy is still not dead and it is still very common to associate low interest rates and low bond yields with easy monetary policy. Just think of the ECB’s insistence that it’s monetary policy stance is “easy”.

In my previous post I demonstrated that all the major changes in the S&P500 over the past four years can be explained by changes in monetary policy stance from either the ECB or the Federal Reserve (and to some extent also PBoC). Hence, it is not animal spirits, but rather monetary policy failure that can explain the volatility in the markets over the past four years.

What holds true for the stock market holds equally true for the bond market and the development in the US fixed income markets over the past four years completely confirms Milton Friedman’s view that tighter monetary policy is associated with lower bond yields. See the graph below. Green circles are monetary easing. Red circles are monetary tightening. (See more on each “event” in my previous blog post)

I think the graph very clearly shows that Friedman was right. Every time either the ECB or the Federal Reserve have moved to tighten monetary policy long-term US bonds yields have dropped and when the same central banks have moved to ease monetary policy yields have increased.

Judging from the level of US bond yields – and German bond yields for that matter – monetary policy in the US (and the euro zone) can hardly be said to be  easy. In fact it is very clear that monetary policy remains excessively tight in both the US and the euro zone. Unfortunately neither the Fed nor the ECB seem to acknowledge as they still seem to be of the impression that as long interest rates are low monetary policy is easy. I wonder what Friedman would have said? Well, I fact I am pretty convinced that he would have been very clear and would have been arguing with the Market Monetarists that monetary disorder is to blame for this crisis and we only will move out of the crisis once the Fed and the ECB move to fundamentally ease monetary conditions and adopt a rule based monetary policy rather than the present zig-zagging.

PS See also my early post on the connection between monetary policy and the bond market: Understanding financial markets with MV=PY – a look at the bond market
Update: Scott Sumner just made me aware of one of his post addressing the same topic. See here.

Update 2: Jason Rave has kindly reminded me of this Milton Friedman article, which also deals with the interest rate fallacy.

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