Wednesday, September 21, 2016

The Bank of Japan: Monetary Mastery or Quantitative Quagmire?

The New Abenomics Program
The Bank of Japan (BoJ) just launched a new phase in its monetary easing program popularly known as Abenomics. It is doing so in the hopes of shoring up economic growth. This monetary program until today had involved a targeted expansion of the monetary base at ¥80 trillion a year matched by ¥80 trillion in government bond acquisitions. There were also targeted purchases of ETFs and REITs on a smaller scale.1

The new phase unveiled today consist of three key developments. First, the BoJ will target the 10-year government bond interest rate at zero percent. Second, it will aim to overshoot its 2% inflation target so that it is truly symmetric. Third, it will drop its quantity target for the monetary base and simply make its expansion conditional on the inflation overshoot. Everything else in Abenomics remains roughly the same. 

So has the Bank of Japan finally mastered its monetary conditions in a way that will spur economic growth? Or is this just another step into the quantitative quagmire of Abenomics? The short answer: do not get your hopes up. There are two reasons why this probably will not make much difference. 

First, the BoJ is pegging the 10-year yield on government bonds at a level it would be at anyways. Because of slow global economic growth and continued uncertainty, yields on safe assets around the world have been falling since 2008. This race to the bottom for safe asset yields can be seen in the figure below:

Over the past eight years, this downward march of yields has occurred before, during, and after various QE programs. So while it is true that the BoJ has been the marginal buyer of Japanese government bonds over the last year, its actions are only doing what the global bond market was already doing and would have continued to do in the absence of BoJ actions. Put differently, the market-clearing or 'natural' interest rate that is based on fundamentals has been falling for some time and is already very low. The BoJ's new long-term interest rate target simply is a recognition of this fact. So there really is nothing new here.

Second, there is a serious credibility issue when it comes to the expansion of the Japan's monetary base. As seen in the figure below, the monetary base has seen a three-fold increase in its size since the beginning of Abenomics. If this expansion were truly permanent, then the price level would also increase threefold over the long-run. There is no way that can happen. The population is aging and depends increasingly on fixed income. Inflation for them is a non-starter. There is no political economy support for such a radical change in the price level.

Here is why this matters: some  portion of the monetary base injection (above that needed for normal money demand growth) needs to be viewed as permanent in order for spending and inflation to rise. If monetary injections are expected to be temporary they would do little to spur spending. If they are viewed as permanent, however, they would raise the expected future price level and thus temporarily push up expected inflation. The higher expected inflation, in turn, would spur robust spending in the present. But this requires some portion of the monetary base growth to be seen as permanent.

The problem, though, is that the expansion of the monetary base has been so large there is no way this growth can be seen a permanent for fear of excessive inflation taking off. The BoJ wants 2% inflation with some overshoot. If the threefold increase of the monetary base were made permanent, the BoJ would get 300% inflation with overshoot! Put differently, the massive expansion of the BoJ's balance sheet undermines its very goal of raising nominal spending and inflation.

So making the growth of monetary base conditional on inflation hitting its target is not credible. The monetary base is simply too large for the BoJ to get any traction this way.

So Does Abenomics Matter?
With all that said, Abenomics has been able to spur some aggregate demand growth and some inflation. Just nowhere near where the government wants it to be.  Below is a figure that shows the level of nominal spending (as measured by nominal GDP) for Japan.  Nominal spending has grown under Abenomics, far more than under the origional QE program of 2001-2006:

I used to think this moderate success was because the monetary base expansion under Abenomics was permanent. But now that the monetary base has gotten so large, I am doubtful for the reasons laid out above. So Abenomics has been moderately successful, but it is not entirely clear to me why this is happening.

It is worth noting one of the goals of Prime Minister Shinzo Abe's government is to raise nominal GDP to ¥600 trillion by 2020. Yes, Japan has a NGDP level target. The Prime Minister first called for this goal in September 2015 and spoke to it again in December 2015.  Since then, it has been in the government's economic and fiscal projections For example, here is the July 2016 executive summary of the projections. The nominal GDP goal stated near the top of the document.  

When the goal was first introduced, it was an ambitious 20% growth  goal for Japan's nominal GDP. It is now closer to 17% given the growth of nominal GDP since then, but this still remains a very ambitious goal as seen in the figure below. This figure shows different paths towards the ¥600 trillion by 2020. 

All of these paths seem ambitious given the recent growth rate of nominal GDP in Japan. It is not clear how to get there without having a major overshoot of inflation.  Maybe the BoJ could reiterate the governments nominal GDP level target and try to communicate that some small portion of the monetary base will be permanent and that it will be injected via purchases of perpetual government bonds. Admittedly, this would be a tough message to communicate. But it is not clear what alternatives there are for Japan. 

So to answer the question in the title to this post, I suspect Japan may be heading further into a quantitative quagmire rather than mastering its monetary conditions. 

P.S. Yes, the markets seem happy about this development so far. But they also seemed happy about the ECB's added stimulus in March 2016. That euphoria did not last and neither will this reaction to the BoJ. 

1ETFs were and continue be purchased at annual rate of ¥9 trillion while REITs are purchased at a targeted rate of ¥60 billion.


  1. Nice post. Your skepticism was subsequently, or concurrently, shared by markets. The press conference saw the JPY bottom out and then gain back more than it had lost. Clearly the personal guidance was at best confused. Oh dear.

  2. Valid points of concern. But still, this can be seen as a net positive if we assume they will follow up with monetization sometime soon. Mikio Kumada

  3. A great post. Also fantastic podcasts, by the way. Extremely informative, especially the diversify of viewpoints you've carefully selected for the series. Brilliant...

    Anyway, wouldn't you agree that the Bank is introducing overshooting tolerance for a reason? My take is that it is ridiculous to do it now without any future easing plan in mind (although such insanity cannot be ruled out yet). Perhaps they can start implementing the incremental debt conversion at the end of the year? Or cut rates further and tie that to forecast updates...?

    1. Yes, that is possible. And I like the way you frame it: 'incremental debt conversion'. Hopefully, they can do that without it causing markets to overact. That is the key issue, in my view. How to lose a little inflation fighting credibility without losing all of it or causing inflation expectations to explode. Best of luck to BoJ, but I'm not holding my breath.

  4. Your blog is great, and your podcast is the best! But I still have some problems to understand how would a permanent increase in MB lead to higher inflation. What's the mechanism?
    In my humble view the increase in Reserves is *ONLY* allowing the banks to lend money to the economy without having to look for reserves afterwards (because they already have them). But the lending process still depends on credit demand as is not (as it never was, following a competent Central Bank) reserve constrained.
    I would like to know your opinion, and by the way an opinion to my blog too (
    Thank you
    Best regards

    1. Thanks for the kind words. The basic idea is that if the public expects a permanent injection they will start responding in expectation of the soon-to-come inflation. The monetarist story is that nominal money demand would fall. The New Keynesian story is that the temporary burst of higher inflation would lower the real interest rate (at the ZLB). Both would spur spending. This spending, in turn, would increase economic activity and raise the demand for credit. Banks, in turn, would respond to increased credit demand and better economic outlook with more lending.

    2. Thank you. But my doubt still stands. As I heard that there is no money multiplier, the increase in reserves should have no effect in M2 whatsoever. So the increase in inflation would only come through the expectations channel?
      But if the increase in reserves does not cause an increase in lending isn't that an irrational expectation?
      Maybe I am not seeing the point, but I would really like to understand your point

      Thank you

  5. David, Very good post. I'd just add one thing. While the Abe government has a 600 trillion yen NGDP target, the BOJ does not have any such target. So I regard the figure as a vague goal, not an actual monetary policy target.

    1. Thanks Scott. Yes, I was wondering about that. It is strange that the the BoJ has one target and the government another. Surely, this adds noise to the signal the BoJ is sending.

  6. Great post, David.
    I am sceptical that the new policy will have the desired effects. The steps of the BOJ are inconsistent, because they introduce a symmetric inflation target at 2% and, at the same time, introduce a 0% target for 10y government bond yields, which is as you mention about where bond yields are now. The symmetric inflation target should imply that average inflation is somewhat higher over the next 10 years. If the markets really believed that the BOJ will provide a higher average inflation rate we should observe an increase in 10y bond yields because of the Fisher effect. If higher inflation expectations would spur economic growth this increase would be even larger. At the same time, however, the BOJ wants to hold the bond yield at its current level, signaling that it is happy with where inflation expectations and economic growth are at the moment. Am I missing something?

    1. Daniel, that is a great point. Yep, there is an inconsistency there. If inflation were expected to shoot above its target and then settle down at 2% we would expect the 10-year yield to go up instantly via the fisher effect. If that were truly happening and the BoJ pegging long-term rates at 0% then we would expect to see an explosive inflation situation take off. But we don't. Another reason to be skeptical. Great observation.

  7. Thanx professor,
    Personally -not an economist=- i fail to see why GE should trigger inflation at all, especially with NIRP. This why (as also stated today in other words by Bill Lee from Citi at Bloomberg):
    Everything is deformed, yield curves, asset prices, and zombie companies are kept alive, like in energy, because of the NIRP. So there will be too little wage inflation, (too much) overproduction , etc. This will negatively effect productivity (down since start of internet and possibly for this reason: the internet and the fourth industrial revolution) and commodities and other prices to fall. Asset prices increase because of Wall Streets' carry trades; main street misses out and another impetus for not inflating the real economy.
    How should any 'rate targeting' have any positive affect on either Japan nor on the US or Europe where, apoplactic politicians, wait on and see how central banker, quite frankly, have already failed to do the heavy lifting??
    I fail to see how 'the increase of BOJ balance sheet not considered permanently' has got much to do with it in the real world..

  8. Some theories are not even wrong (ones that are usually based on statements that are not falsifiable).

    First example - "BoJ is pegging the 10-year yield on government bonds at a level it would be at anyways": This needs, among other things, a chart with a larger range of time (going beyond the global QE period) in the least, to show yields would have gone down anyway. And even if it is playing with the market now, targeting a yield also includes promises about future. A more credible promise than QE in fact, when the bonds to buy are about to run out.

    Second example - permanent increase in base money leads to inflation - " a serious credibility issue when it comes to the expansion of the Japan's monetary base": US also had a tripling of base and not a three-fold inflation. So this proves a credibility issue for both (actually it does not, but anyways), or for none.

    You are suggesting basically for helicopter money in some form. I probably agree it is needed (may be not desired). Question is what if that fails. That is one scary question.

  9. Easing credit in an attempt to to ease fluctuations in the business cycle has several negative consequences that many economists seem to miss. Firstly, by doing this Central Banks subsidize the financial services industry because the credit easing they employ to help the real economy must first go through the financial system. As leverage in the economy increases, the size of the financial industry grows as well.

    Secondly, the more leverage goes up, the less effective the credit easing process becomes and the more dangerous/fragile the system becomes.

    Thirdly, credit easing to create inflation is inherently regressive as wealthy and sophisticated people tend to borrow to invest or buy productive assets while average people tend to borrow to purchase consumer goods.

    I am of the opinion that central banks can't create growth, they can only act to stem financial panics as they did in 2008-2009.

    When there are structural problems in the economy, easy credit will go to M&A and financial speculation as businesses won't have the confidence ot invest in the real economy. Instead, they will merely swap debt for equity because of the cost arb available to them (thanks to Central Banks asset purchase programs)

    Japan's central bank can do nothing about the shrinking population/aging demographics that are the core drivers of a deflation bomb that went off after the world's largest asset bubble burst in the early 90s.

    Policy makers miss the real lessons from the Japanese issue-monitor credit flows/financial speculation. There should be monitoring of credit growth in relation to nominal GDP.

    Helicopter money is the only way out for Japan, but that is because of their balance sheet problems in the context of a shrinking population/increasing liabilities due to aging/medical care.

    Excessive easing via the credit channel always leads to a deflationary bust, eventually. There is a lot of empirical evidence for this, but because it doesn't come with a DGSE model that macroeconomists can 'understand' they refuse to accept this truth. :(

    1. mon policy makers are trying to change people's behavior by targeting price of credit, but there is a lot of evidence that they have no idea how and why people actually go about making decisions. The problem in the world today is too much debt in relation to global economic activity, and perhaps an "overly financialized" economic system in many of the advanced economies.

      Debt jubilee/helicopter money or defaults on a somewhat large scale only way to deal with these issues.

      Other problem holding down growth- aging populations across every major economy w the exception of India..

    2. Not surprising that policy makers don't really understand the distortions that their policies create..many of their models only recently started factoring in impact of financial system LOL