Monday, November 27, 2017

Abenomics Update

So a quick update on that grand monetary experiment in Japan known as Abenomics. 

Prime Minister Shinzo Abe and his party were returned to power in a decisive October election. This means the Bank of Japan will continue to expand the monetary base, peg the 10-year government bond at 0%, and strive for 2% inflation. 

I was an early fan of Abenomics, but have become a bit more skeptical over time. Others, like Noah Smith, are convinced it is working and are glad to see it continue. Mike Bird of the Wall Street Journal is also a fan. They make a reasonable argument that the real side of the economy has benefited from the Bank of Japan's policies. 

Maybe so, but what about the nominal side of the economy? Yes, we ultimately care about the real side, but the central bank can only directly affect the nominal economy. Its influence on the real economy is a by-product of this influence. Moreover, getting the nominal side of the economy to rapidly expand is needed to offset the real burden of the growing stock of nominal debt. 

So how is the nominal side of the economy doing? Okay, but not great. Inflation is above zero but nowhere near its 2% target. This is true even if we look at core measures of inflation that account for the 2014 changes in the consumption tax. Below is a chart from the Bank of Japan:

Nominal GDP (NGDP) in Japan--a measure of total nominal demand--does show more progress under Abenomics than with the original QE of 2001-2006:

This progress of NGDP is an improvement, but if we step back and look at it from a broader historical perspective it is actually underwhelming. All Abenomics has done is return NGDP to a flat trend growth path. Nominal demand growth in Japan is still far below what it was before the 1990s. This has big implication for Japan's debt burden and suggests its real growth could be higher.

So why is Abenomics failing to pack a big punch? There is both an economic and a political answer. The former is a technical one that can be summarized in the chart below. It shows the actual monetary base and its permanent portion. (The permanent portion is proxied by currency and coins in circulation since they tend to drive the long-run path of the monetary base.)

The expected path of the permanent part of the monetary base and by implication the expected path of the price level is what drives current inflation. If the expansion of the monetary base under Abenomics is expected to be unwound in the future then it should have little effect on the price level today. The permanent portion of the base suggests it will be unwound. (I have a forthcoming paper that explains in more detail why this permanent-temporary distinction matters so much.)

Another way of saying this is that market participants expect the Bank of Japan to do what it did after the initial QE program--reverse it. Michael Woodford, in his 2012 Jackson Hole speech, commented on the 2001-2006 episode:
The Japanese monetary base resumed a path that was close to a continuation of its trend prior to the QE period; hence, market participants who had continued to hold expectations about the long-run Japanese monetary base that were unchanged as a result of the QE policy would not have been that far off in their prediction (p. 241).
Woodford also notes that this experience comes “fairly close to providing an illustration of the kind of policy to which the irrelevance results of Krugman (1998) and Eggertson and Woodford (2003) should apply". This is the economic answer and the reason I have become more skeptical of Abenomics.

The political answer, in my view, is that the Bank of Japan will not make its monetary expansions permanent and significantly increase the inflation rate is because politically it cannot do so. Japan has an aging population that holds a lot of government debt and lives off of fixed income. Raising the inflation rate would harm them and create a political firestorm. I believe this is what ultimately is keeping Japan from getting robust nominal demand growth. 


  1. David:

    I really enjoyed the excellent paper "Permanent versus temporary…."

    But back to Japan, it is there any sense the Bank of Japan will ever sell off its balance sheet? I sure detect none. Does that make the monetary expansion permanent or not, or fall into a grey zone?

    Adair Turner suggests the BoJ will never sell its balance sheet.

    BTW, some good news lately from Japan, with Nikkei 225 hitting highs, and inflation moving towards 1%, and this:

    “TOKYO — Major Japanese companies sharply upgraded their plans for capital investment spending in fiscal 2017, by 15.8% from the year before, the largest increase since the peak of the country’s asset-inflated economy in 1990, a Nikkei survey showed on Saturday.”

    One "problem" that Japan has in hitting inflation targets is that housing is cheap, and people can build in Tokyo (a growing city).

    Such a problem we should have.

  2. Add on: If the Bank of Japan tomorrow indicated it would hold onto its balance sheet through maturity, would that result in inflation in Japan?

  3. Thank you for your nice update of Abenomics.

    Like you, I was also a early proponent of Abenomics, and like you, I am now a critic of Abenomics, particularly after 8% consumption tax hike (April 2016), and Kuroda BOJ’s Halloween bazooka(Oct. 2016).

    I am also in favor of your suggested NGDP targeting policy in general.

    I am not sure, however, if permanent monetary expansion could make great sense either in Japan or USA.

    In particular, Japan’s NGDP amounts to about 530 trillion yen. The BOJ’s asset or debt size now stands at about 510 trillion yen. It is clear that the BOJ would hit the entire size of the economy very soon, given the slow growth of the NGDP and the rapid pace of the BOJ’s monetary expansion.

    Does it make sense to anyone, irrespective of the nature (permanent or temporary) of the very expansionary monetary policy?

    My back-of-the-envelope calculation suggests that the Japan’s central bank could suffer from huge loss in the near future, amounting to about 80 trillion yen (about 16% of the NGDP) assuming 2% inflation, and 2% nominal interest rate (could be 3% given 2% inflation) with the bank’s holding of long term government debt amounting to 400 trillion yen, and with average 10 year duration (i.e. 80 trillion yen = 400 trillion x 10years x 2% rise of interest rate).

    Such large rises of both rates of inflation and interest, if and when being materialized, could be not only politically unacceptable but economically catastrophic.

    In light of your suggested NGDP targeting policy, I would rather recommend to the Japan’s government a permanent and expansionary fiscal policy such as cutting 8% consumption tax back to 5%.

    At the same time, I would suggest to the BOJ it normalizes its currently very expansionary monetary policy as soon as possible. A Taylor-rule suggests the Bank’s policy interest rate should be now raised to 0.5% from -0.1%, given 0.2% core CPI inflation and 0.5% output gap with the aggregate demand exceeding the aggregate supply.

    In any case, Japan’s economy enjoys external surplus position with its saving surpassing the investment. She has a room to undertake permanent fiscal expansion to attain both internal and external balances.

    With continued permanent monetary expansion, the size of the BOJ’s balance sheet could explode, and given the scheduled downsizing of the FRB’s balance sheet, the dollar yen rate could also skyrocket from current 112 yen to about 150 yen by the end of 2018, in accordance with the so-called Solos formula by dividing the expected size of the BOJ by the scheduled size of the FRB.

    In sum. I fully agree with your suggested NGDP targeting policy in general. However, NGDP targeting policies using monetary policies alone do not make sense in two country models setting, due to their beggar-thy-neighbor nature. NGDP targeting policies should be conducted with due consideration of international policy coordination under alternative currency regimes.

    Best regards,

    Tomo Nakamaru

    An Ex-World Banker and Chief Economist at Macro Investment Research Inc.

  4. I found some serious factual errors.
    8% consumption tax was hiked in April 2014, and Kuroda BOJ's Halloween Bazooka was fired in Oct. 2014.

    Sorry about the errors.

    Tomo Nakamaru

  5. Tomo, if the monetary injections were made permanent then they would not need to be so large. The fact that they are so large indicates they are temporary.

  6. David,

    Are you saying that if we visited the financial district in Tokyo and spoke to the folks working there they would actually say to you the words "We believe BOJ's expansion of the monetary base is only temporary, we expect it will eventually be almost completely unwind, and we have adjusted our trading behavior accordingly".

    In other words, is the permanent/temporary distinction an actual conscious belief that market participants have or is it merely implied by their actions?

  7. Very good post, David.
    Also, I read, enjoyed reading, and agreed with your paper on permanent vs temporary monetary expansion. In this regard, you may be interested (and I'd really like to invite you to read and have your views on) this piece of a couple of years back: Many thanks