By Ankit Mittal, Quantitative Research
This is our second post on Japan’s new economic project.
The newly appointed Bank of Japan (BOJ) Governor Haruhiko Kuroda shocked the market by announcing the “massive” monetary easing at his first policy meeting on April 4, 2013. Consensus expectations before the BOJ policy meet was that Kuroda would under deliver, demonstrated by the appreciation of the Japanese yen before the announcement. However, Kuroda over delivered, announcing a new policy package, including the following:
- Doubling the monetary base in two years (also changing operating target from call rate to monetary base1)
- Increasing the average maturity of the BOJ’s Japanese Government Bond (JGB) holdings and extending the maturity of bonds, eligible for purchase, from 3 years to 40 years
- Increasing the purchase of risky assets (ETFs & REITs)
- Continuing easing until a 2% inflation target is achieved
Following the announcement, the yen lost more than 5% of its value in just two days.
A return to monetary aggregates and Bernanke’s prescience
The BOJ has somewhat turned back the clock by abandoning interest rate in favor of monetary base as its operating target. None of the central banks of major advanced economies has used monetary aggregates as policy tools since the 1980s. Another interesting aspect of the BOJ’s new measures is their similarity to Ben Bernanke’s suggestion in a famous speech delivered in 1999. His suggestions—higher inflation target, weaker yen, significant increase in money supply and JGB purchases—are now part of Japan’s new economic policy.
Monetary stimulus in major economies since crisis
What has caught the imagination of the market is the BOJ’s commitment to double the monetary base in two years. Surprisingly, this is not very different from what central banks in the United States, the United Kingdom, and the eurozone have done since the 2008 financial crisis. The balance sheets (close proxy for monetary base) of the Bank of England, the Federal Reserve and European Central Bank are now about 5.1, 3.7, and 2.3 times their pre-crisis levels, respectively. The BOJ’s new policy, along with other relatively small bouts of QE undertaken since 2008, will bring its balance sheet to 2.5 times the pre-crisis level. Based on this matrix, the BOJ’s policy is hardly earth shattering. As a percentage of the GDP, however, the BOJ’s actions seem more audacious. While the balance sheet of central banks in the United States, the United Kingdom, and the eurozone stand between 20% and 28% of the GDP, the same figure will rise to about 58% for Japan (from the current 35%) by the end of 2014. The discrepancy arises because the BOJ’s balance sheet still carries the asset accumulated during the unsuccessful policy interventions from the late 1990s to 2006. To highlight the scale of the current policy again, the BOJ will likely purchase assets worth ¥60–70 trillion ($70–$80 billion) per month in 2013, not much less than the U.S. Fed purchase of $85 billion per month at present, in an economy that is one-third of the U.S. economy.
Sources: Bloomberg, IMF
The repercussions of such easing in the United States, the United Kingdom, and the eurozone have not been very dramatic. While their currencies have depreciated, they haven’t exactly fallen off the cliff. Inflation too, barring the United Kingdom, has been below the target in these economies for most of this period. Inflation in the United Kingdom (2–5% since the crisis) has been higher on account of higher VAT and energy prices. This has primarily happened because demand continues to be weak and inflationary expectations are well anchored due to the credibility of central banks in these economies. This experience, combined with the deeply entrenched deflationary expectations in Japan, suggests that the new policy package is not a recipe for hyperinflation or large scale currency debasement, as suggested by a few commentators.
Monetary transmission in Japan – historically
The increasing supply of money cannot create inflation on its own, unless there is a demand for those funds. Deleveraging and risk aversion have ensured that the channels of monetary transmission remain clogged. Balance sheet recession from the 1990s to the early 2000s has sapped any appetite to borrow from the Japanese households and businesses. Deflationary expectations ensure that money is hoarded rather than spent. Thus, broad money2 has not grown despite the rapid expansion of monetary base. This is important, because the prices will rise only when base money circulates in the economy and becomes broad money. The evidence on these relationships over the last three decades (1981–2012) in Japan is presented below.
As we can see, there is no observable relationship between base money and inflation in Japan over the last three decades, even after we account for a one year lag for transmission. We do, however, find a positive association between broad money and inflation. Finally, we can see that there is no apparent relationship between base money and monetary base. Therefore, unless monetary transmission starts working again, inflation is unlikely to respond to the monetary base expansion.
Monetary transmission in Japan – today
This puts the BOJ’s actions in context. The BOJ’s ‘shock and awe’ policy aims “to drastically change expectations of markets and economic entities” conditioned by years of deflation. However, the economy will need to deliver rather quickly over the next one or two years in terms of positive inflation and better growth for expectations to be sustainably changed. Otherwise, the ‘shock and awe’ too will fizzle out, once people do not see any impact on the ground.
Apart from a weak yen and rising market expectations of inflation, exports, consumer sentiment, and domestic lending look slightly positive this year, perhaps showing early signs of the new policies making an impact. Moreover, there have also been some reports of wage increases. On the other hand, an air of pessimism, fed by two decades of deflation and balance sheet corrections, seems to hang over businesses. This is reflected in low credit offtake and a preference for overseas expansion rather than domestic, despite a weaker yen. The sentiment was reinforced days before the BOJ’s announcement of the new policy, when Shinzo Abe admitted, quite uncharacteristically, that the inflation target may not be met in the next two years.
There is concern that monetary transmission may work only via a weaker exchange rate, while private domestic borrowing remains sluggish. This would create a divide between the tradable sectors and the rest of the economy and is, therefore, unlikely to lead to broad-based growth and inflation. Moreover, reliance on a weaker currency to boost exports will limit incentives for innovation, diminishing the long-term prospects of the export sector. The fate of former market leaders such as Sony is illustrative. Therefore, if sluggishness continues in the private sector and monetary transmission via commercial banks does not work, deficit spending by the government would only be able to raise broad money and therefore, increase growth and inflation.
This puts Japan’s precarious public finance situation in the spotlight. The BOJ-engineered higher inflationary expectations can potentially raise JGB yields, limiting fiscal space. While both the United States and the United Kingdom have been able to keep yields low, and, at the same time, keep the inflationary expectations significantly positive, recent volatility in JGB is a cause of concern. George Soros recently lamented that the current policy would have been great if it was implemented 15 years ago, when the public debt figure was not so high. While the taboo associated with downgrades has certainly reduced, S&P’s recent downgrade warning reflects the risks associated with the Japanese economic project. If the volatility gives way to higher yields, it would not only signal a failure of the BOJ policy, but would also endanger Japan’s fiscal stability. It would also be catastrophic for large holders of government bonds like banks, insurers and pension funds. Recent anecdotal evidence suggests that Japanese investors are looking to move out of JGBs to the United States, or the Antipodes, or eurozone sovereign debt to escape near-zero yields. JGBs attractiveness to foreign buyers has also diminished due to a depreciating yen. Therefore, it is very important to keep an eye on the performance of JGBs, lest the mother of all monetary stimuli gives way to the mother of all fiscal crises.
1Monetary Base/Base Money (M0): This is the currency supplied by the Bank of Japan. It is defined as Monetary Base = Bank notes in circulation + Coins in circulation + Current account balances in the Bank of Japan.
2Broad Money (M3): This includes currency in circulation, deposit money, quasi-money, and certificate of deposits (CDs) issued by depository institutions. It represents the broadly defined liquidity in the Japanese economy.
This is our second post on Japan’s new economic project and a lot has changed since our first post at the beginning of this year. The international community has largely countenanced the yen’s depreciation; self-imposed restrictions (banknote principle and maturity) have been done away with; institutional reluctance seems to have been overcome; and unlike previous instances, the markets, not BOJ interventions, have driven the depreciation. These developments could now see the yen stabilize at a lower than anticipated level.