How is Abenomics Doing?

In my previous post, I noted how the monetary policy portion of Abenomics (the "first arrow") appears to be working. Japan has grown more rapidly than the United States and the Eurozone. This success appears to be the result of its new found enthusiasm for monetary policy. And it is not just any kind of monetary policy, but one that signals a regime change at the Bank of Japan. This regime change commits the Bank of Japan to raising the nominal size of the economy by permanently expanding the monetary base. Martin Wolf agrees:

Of the three arrows, the first is most likely to hit the target. In January the Bank of Japan adopted an explicit target of 2 per cent consumer price inflation. But it was only after the appointment of Haruhiko Kuroda, an outsider, as governor that a new approach was born. Under his leadership, the bank announced its ambitious programme of “quantitative and qualitative easing”, or QQE. The aim is to deliver the inflation target “at the earliest possible time, with a time horizon of about two years”. The central bank committed to doubling its holdings of Japanese government bonds over two years and more than doubling the average maturity of those holdings. Christina Romer of the University of California, Berkeley, former chair of the US Council of Economic Advisers, hailed this as a “regime shift”, comparable to America’s decision to go off the gold standard in April 1933.

Ambrose Evans-Pritchard makes a similar point:

Japan, too, has grasped the nettle, breaking free of its deflation trap with the most radical policy experiment of modern era...After two decades of monetary tinkering the Bank of Japan is mopping up 7.5 trillion yen worth of bonds each month, almost as much as the Fed in an economy barely more than a third the size. It is buying long-term debt for the first time...

Japan was the fastest growing economy in the OECD bloc in the first half of this year. There was a hiccup in the third quarter, causing the faint-of-heart to write off Abenomics. Yet Nomura's Shuichi Obata says the December Tankan survey of business shows that confidence is at last spreading from big companies to small firms, with the services index rising above zero for the first time since 1991. 

Michael T. Darda, Chief Economist of MKM Partners, tells us that not only has Japan done well so far, it looks set to do well again next year:

Leading indicators in Japan have been on the upswing. The OECD’s Leading Index and the Tankan business sentiment survey have been in multi-month upswings, suggesting faster future growth. 

 

In other words, Abeonomics is working. One reason that the previous round of QE in Japan didn’t lift growth much is that it was expected to be temporary and proved to be temporary as occasioned by a 20% collapse in the monetary base in 2006. This time, however, at least part of the increase in the base is expected to be permanent, hence the new 2% inflation target. In short, the BoJ has to do enough to satiate a broad money demand function that has been growing 2-3% per annum.  (DB: for more on the importance of permanent monetary injections see here)

Reflation should help to ease Japan’s debt and fiscal burden. One reason for Japan’s high debt ratio (perhaps the main one) is that nominal GDP growth has been trending at zero for more than 15 years. That means at any positive nominal bond yield, the debt ratio is likely to rise. Thus, restoring at least moderate NGDP growth should help Japan’s budgetary fortunes. This is one reason that the rise in Japan’s inflation breakeven spreads has been inversely related to credit default swap spreads on Japan’s debt. 

Broad money growth in Japan has begun to recover convincingly, which should also be bullish for the equity market. Broad money growth now has exceeded to growth rates last seen during Japan’s multi-year growth period of the early 2000s. Milton Friedman would be proud, as he advocated the policies now going into place back in 1998. We believe Japan equities have 20-40% upside, assuming the valuations seen back in the early 2000s are met or exceeded.  

  

This is great news for Japan. However, as Martin Wolf notes, this first arrow only addresses the cyclical portion of the Japanese economy. There are still huge structural problems that seem unlikely to be resolved anytime soon. Still, this is one big step forward for an economy burdened by malign deflation for the past few decades. 

The QE Block versus the EMU Block

 Source

The always colorful Ambrose Evans-Pritchard has done it again. He has cleverly framed the varying monetary policy responses in the advanced economies as falling under either the QE block or the EMU block. As he notes, the evidence is clear as to which block has done better:

The US, UK and Japan are all recovering, moving closer to "escape velocity". The Swiss National Bank - that bastion of orthodoxy - has kept its economy on an even keel by quietly amassing a bond portfolio equal to 85pc of GDP.

The crippled eurozone alone has chosen to stagger on defiantly without monetary crutches. The result has been a double-dip recession of nine quarters, the longest since the Second World War. The austerity regime has been self-defeating even on its own crude terms. Debt ratios have ratcheted up even faster.

[...]

 
The diverging fortunes of the QE bloc and the EMU bloc prove beyond doubt that monetary stimulus packs a powerful punch. Without becoming entangled in the vendetta between Friedmanites and Keynesians - I value the insights both in the post-bubble phase, as well as "Austrian" insights before the bubble builds - the central bank experiment of 2008-2013 shows that blasts of money can greatly offset the pain of budget cuts, even when interest rates are zero.

This is a point I have repeatedly made on this blog. The more intense the monetary policy response, the greater has been the economic recovery. That is why over the past year the recovery in Japan has outpaced the one in the U.S. which, in turn, has outpaced the recovery in the Eurozone. This pattern can be seen in the figure above.

Evans-Pritchard goes on to describe the QE critique coming out of the EMU block:

You hear a refrain in Berlin and Brussels that the recovery of the QE bloc is somehow feckless, phony and illegitimate, that the money printers are just building up more debt, putting off their day of reckoning while Europe takes its punishment early. Nothing could be further from the truth. 

I agree, but for a different reason than Evans-Pritchard lays out in his piece. Specifically, those who see a debt crisis in Europe are only seeing a symptom of a more fundamental problem: a collapse in nominal income. This is a problem that the ECB could have prevented. The collapse in Eurozone nominal income created the debt crisis, not the other way around. The ECB allowed this collapse to emerge because its policies have been, until recently, effectively geared toward Germany. This is a point Ramesh Ponnuru and I have made before:

[Observers] tend to think of Europe’s current crisis as the result of overspending welfare states. And these states would indeed be better off with lower spending levels and less regulated labor markets. But many of the nations swept up in the euro-zone crisis, such as Spain and France, had spending and tax revenues well aligned before it hit. The true problem has again been monetary. Europe has for a decade had a monetary policy well suited to the circumstances of Germany but not to those of the rest of the euro zone and especially its periphery. Nominal income in Germany has stayed on a fairly steady trend line. In the periphery, however, it first went way up and then crashed. For the euro zone as a whole, nominal spending has fallen far below its previous trend—and has been continuing to fall farther away from it. Monetary policy therefore remains very tight in the euro zone overall. One effect of that drop-off, in Europe and in the U.S., has been to make debt burdens more onerous.

The figure below illustrates this point. It shows that below-trend growth in Eurozone nominal income--as measured by how far NGDP is from its pre-crisis trend path--has been matched by a similar rise in Eurozone government debt. The Eurozone crisis, then, is a nominal GDP crisis, not a debt crisis.

The QE programs have been far from perfect, but they seem to have made a difference. Consequently, my bet is that history will be kind to policy makers in QE Block and frown upon those in the EMU Block.

QE, Rising Yields, and the Right Way to Taper

Matthew O'Brien of The Atlantic gives us the 41 most important economic charts of 2013. The figures come from various contributors, including me. My figure is borrowed from chief economist Michael T. Darda of MKM Capital and shows that long-term treasury yields generally have risen under the QE programs. This pattern runs contrary to the stated objectives of the Fed and is also inconsistent with those who claim the Fed's large scale asset purchases (LSAPs) are draining the financial system of safe assets. Fortunately, there is a way to make sense of these developments.

The chart I borrowed from Darda came from a longer note that had other interesting charts and comments. I thought you might like seeing the rest of them, especially his thoughts on how to taper without tightening monetary policy. Here is Darda:

Most observers continue to (falsely) believe that QE works by lowering long rates and flattening the yield curve. However, a quick look at the data suggests this is not the case.

The Great Macroeconomic Experiment of 2013

In early 2013, Mike Konczal wrote the following:

In late 2011, the economist David Beckworth and the writer Ramesh Ponnuru wrote an editorial in the New Republic on how “both liberals and conservatives are wrong about how to fix the economy.” How were they wrong? Conservatives were wrong because, contrary to common belief on the right, the Federal Reserve wasn’t in fact doing enough to boost the economy. Liberals, however, were wrong in opposing austerity and calling for more fiscal stimulus in the form of stimulus spending or temporary tax cuts.

In Beckworth and Ponnuru’s view, the Federal Reserve still had plenty of room to boost the economy. Not only would fiscal tightening be good over the long haul, but it would force the Fed to act. And they argued that as long as the Fed is working to offset austerity, the country “won’t suffer from spending cuts.

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments -- specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

So how has this experiment unfolded since then? Has the Fed been able to offset the fiscal drag? Michael Darda, Chief Economist of MKM Partners, has the answer:

Despite a two-year contraction in nominal federal outlays for the first time in more than five decades and a raft of tax hikes starting in early 2013, job gains are running slightly ahead of the 2012 pace. Non-farm payrolls (+203K in November and 200K in October) have averaged 189K during the first 11 months of 2013, ahead of the 179K 11-month average in November 2012 and the 170K average for November 2011. Over the last 12 months, non-farm payrolls have averaged 191K, also above the 12-month averages for the last three years. Indeed, year-to-year gains for overall payrolls and private sector jobs have been very steady despite the most intense fiscal consolidation since the Korean War demobilization. Many observers late last year were of the mindset that the fiscal cliff and/or sequester would either throw the U.S. economy back into recession, or slow it materially. It has done neither because, in our view, the Fed has offset it. Although monetary policy has beenfar from perfect, allowing the financialsystem to crash in 2009 (instead of doing QE1), allowing low inflation to morph into deflation in 2010 (instead of initiating QE2) and allowing the full force of the sequester/tax hikes to hit in 2013 (rather than rolling out QE3) do not seem like particularly desirable outcomes. The Fed has managed much better than the ECB and that is the proper counterfactual.

Several points to note. First, the Fed has been offsetting since 2010 a tightening of the structural budget balance as a percent of potential GDP. In my opinion, that is an even more impressive feat. Second, its ability to do so demonstrates that monetary policy is still effective at the zero lower bound. Third, it is amazing that so many people were predicting a recession in 2013 because of the sequester. They did not take seriously the possibility QE3 could offset the fiscal drag. I am waiting for their mea culpa.

The Wrong Debate: Helicopter Drops vs. Quantative Easing

A central theme of this blog is that the economy is still starved of the monetary assets needed to restore full employment. That is, the ongoing shortfall of aggregate demand is at its core caused by a shortage of money and money-like assets relative to the demand for them. The question, then, is what can be done about this problem.

I have long argued, along with other Market Monetarists, that the Fed could solve this problem by adopting a NGDP level target. Why would this help? The key reason is that it would create an expectation that some portion of the monetary base growth from the asset purchases would be permanent (and non-sterilized by IOER). That, in turn, would mean a permanently higher price level and nominal income in the future. Such knowledge would cause current investors to rebalance their portfolios away from highly liquid, low-yielding assets towards less liquid, higher yielding assets. The portfolio rebalancing, in turn, would raise asset prices, lower risk premiums, increase financial intermediation, spur more investment spending, and ultimately catalyze a robust recovery in aggregate demand. (One could also tell a New Keynesian story where the higher future price level implies a temporary bout of higher-than-normal inflation that would lower real interest rates down to their market clearing level.)

The key to the above story is that some portion of the monetary base expansion is expected to be permanent. If the public believes the Fed's asset purchases are not going to be permanent and therefore the price level and nominal income will not be permanently higher, the rebalancing will not take place. I bring this up because this same point applies to helicopter drops or any other kind of fiscal policy stimulus. Yet many of my fiscalist friends miss it. They seem to think that helicopter drop will solve the excess money demand problem, period. That is not the case if the Fed continues to hit its inflation target.

Imagine, for example, that Congress approved a $10,000 check be sent to every household. Even in a non-Ricardian world where households are liquidity- and credit-constrained, the increased private sector spending created by the checks would be offset by monetary policy if it started to push inflation above its target.

This is why helicopter drops by themselves are not a fix. Nor or large scale asset purchases. As noted by Christina Romer, there has to be a regime change in how monetary policy is conducted, one that signals a commitment to a permanent expansion of the monetary base (via a commitment to a higher price level and nominal income). From this perspective, it does not matter whether one does helicopter drops or large scale asset purchases. They would have the same effect if tied to the same target, such as a NGDP level target. 

Michael Woodford has made this point before:

It is possible for exactly the same equilibrium to be supported by a policy of either sort. On the one hand (traditional quantitative easing), one might increase the monetary base through a purchase of government bonds by the central bank, and commit to maintain the monetary base permanently at the higher level. On the other (‘helicopter money’), one might print new base money to finance a transfer to the public, and commit never to retire the newly issued money. Suppose that in either case, the path of government purchases is the same, and taxes are raised to the extent necessary to finance those purchases and to service the outstanding government debt, after transfers of the central bank’s seignorage income to the Treasury. Assuming the same size of permanent increase in the monetary base, the perfect foresight equilibrium is the same in both cases...

However, he notes the two approaches would have different effects if the public thought the permanency of the monetary base injections differed:

The effects could be different if, in practice, the consequences for future policy were not perceived the same way by the public. Under quantitative easing, people might not expect the increase in the monetary base to be permanent – after all, it was not in the case of Japan’s quantitative easing policy in the period 2001-2006, and US and UK policymakers insist that the expansions of those central banks’ balance sheets won’t be permanent, either – and in that case, there is no reason for demand to increase. 

In other words, we should not be surprised that the Fed's QE programs have not packed more of a punch. U.S. monetary authorities have clearly indicated the programs are temporary. (QE3, though, has added some permanency with its data-dependent nature and appears to have offset much of the 2013 fiscal drag.) We should also, then, not be surprised that Abenomics--which has signaled a permanent expansion of the monetary base--is doing so much better than the original Bank of Japan QE program of 2001-2006. Finally, we should also not be surprised as to why FDR's 1933 decision to go off the gold packed such a punch. It permanently raised the monetary base. All of these experiences paint a picture of the relationship between the expected permanency of monetary base injections and aggregate demand growth. This relationship is sketched in the figure above.

So stop worrying about whether large scale asset purchases or helicopter drops are more effective. This is the wrong debate. Instead, start worrying about how we can change the Fed's target to something like a NGDP level target.

P.S. Paul Krugman's 1988 article also implies that the temporary versus permanent distinction is important in determining the efficacy of monetary policy, particularly at the ZLB.

P.P.S. The above discussion is why I have previously argued for helicopter drops to be tied to NGDP level targets.

Update: Compare this picture of Japan's monetary base to those of the U.S. monetary base in 1933.

 

Taking the Model to the Data

Stephen Williamson has generated something of a firestorm by arguing the Fed's QE programs have actually been lowering inflation over the past three years. His argument is based on a new paper of his that builds upon the monetary search framework of Lagos-Wright (2005). I actually like this approach to modeling money-like assets, but the implications Williamson draws about QE has Nick Rowe, Brad DeLong, Paul Krugman, and Scott Sumner up in arms. David Andolfatto valiantly rides to Williamson's defense (update: so does Noah Smith) only to be rebuffed again by Nick Rowe.

I do not want to rehash their arguments here, but I do want to respond to a challenged made by David Andolfatto:

It seems to me that the critics should have instead attacked his results and interpretations with empirical facts (or am I too old-fashioned in this regard?).

Okay, David wants us to take Stephen Williamson's model to the data. Stephen probably thinks he has already done so with this figure of PCE inflation. However, one cannot really draw any conclusion using headline PCE inflation because it has embedded in it supply shocks and other temporary perturbations completely unrelated to monetary policy. This is why the Fed and others look at core PCE inflation. For these reasons, I too will use the core PCE inflation measure here as we empirically examine Williamson's claims.

Below is the figure for core PCE inflation. Williamson's argument is premised on inflation falling over the past three years. This figure suggests something else has been happening: it has been bouncing between 1% and 2%. Ryan Avent argues this is intentional. The Fed's 2% inflation target is actually an upper bound. According to this view, the Fed is more concerned about preserving its inflation-fighting credibility than it lets on in public and effectively is keeping one foot on the brake and one on the gas pedal so that inflation stays in the 1%-2% range. In any event, the point here is it is not clear that inflation has been trending down for the past three years.

Williamson's bigger claim, though, is that the Fed's purchases of treasuries are actually driving down the inflation rate. If this is the case, then we would expect to see a negative relationship between the growth in its holdings of treasuries and the inflation rate. The data, though, suggest otherwise. The figure below shows the year-on-year growth rate of treasuries held by the Fed plotted against the core PCE inflation rate. It appears that Fed's purchases of treasuries leads core inflation by about six to nine months. [Update: here is the figure for longer-term treasuries--it is even stronger.]

To verify this 'eye-ball test', I put the two series in a vector autoregression (VAR) and estimated it once with 6 lags and once with 12 lags. The data was monthly and I estimated the model for the 12/2007-9/2013 period. Below is the Core PCE inflation impulse response function (i.e. typical response) to a positive standard deviation shock to the year-on-year growth rate of the Fed's treasury holdings.The first figure shows the response for the 6-month lag VAR and the second figure for the 12-month lag VAR. In both cases core PCE inflation responds in the same direction as the shock with a lag.

Now these effects are modest, but they go in the opposite direction of that predicted by Williamson. So the data seem to be telling a different story. The Fed's treasury purchases do lead to modestly higher inflation. It is nothing to write home about, but it is definitely not disinflationary.

Again, I like the Lagos-Wright (2005) approach promoted by Williamson. In fact, Josh Hendrickson and I have a paper built on it. In our extension of the model, QE programs can pack a real economic punch if the monetary base injections are expected to be permanent. This is because a permanent injection is expected to permanently raise future nominal income which in turn relaxes current borrowing constraints. The implications of our model, then, is that the Fed's QE programs have not been as effective as they otherwise could be, because all along the Fed has signaled its asset purchases are temporary (though QE3 has added some permanence with its conditional nature). This point about permanent monetary injections is not novel. It has been made many times before by Paul Krugman, Michael Woodfod, Scott Sumner, Bill Woolsey, and others. It is also a point I repeatedly make on this blog. Finally, it is why so many of us are big supporters of level targeting.

P.S. The success of monetary policy in Japan under Abenomics is also hard to reconcile with Williamson's model. Here too, I believe the results are due to the expected permanence of the monetary base expansion.

Update: Mark A. Sadowski provides further empirical evidence that runs contrary to Williamson's claims.