Early lessons from Japan

Given enough time has a past since the BOJ really began to push the envelop in terms of unorthodox aggressive monetary experimentation, the following post uses Bernanke's recent speech (Some reflections on Japanese monetary policy) as a jumping off point to review developments in Japan.  Seeing as Japan could be a precursor for what may be yet to come in the rest of the developed world that still struggles with subpar growth, low interest rates, and a lack of inflation, the BOJ's monetary evolution bears watching. 

Lessons that are still relevant

1.  When short-term policy rates reach the zero lower bound, central banks are not out of ammunition.

I argued instead that central banks have a number of options for further easing financial conditions after short rates hit zero, and my coauthors and I discussed and evaluated many of the policy tools that would be used in the American and Japanese reflation efforts, including forward rate guidance (both unconditional and conditional on economic conditions), large-scale asset purchases, changes in the mix of assets held by the central bank, credit programs based on low-cost central bank lending, and even what in Japan is called yield curve control.2 (I did not however anticipate negative interest rates.)   

In other pieces I argued that central bank purchase programs should focus on longer-term assets and not be concentrated on bills, as had been Japanese practice in earlier forays into quantitative easing.

2.  After a prolonged period of below target inflation and zero rates, an inflation overshoot may be necessary.

I emphasized the need to set an inflation target high enough to provide some buffer against deflation, and I noted that temporary overshoots of the target to compensate for prior inflation shortfalls could be warranted following a period in which rates are constrained by the effective lower bound.

3.  Monetary policy alone can't always adequately deal with large shocks.

I frequently acknowledged the need to complement monetary policy with fiscal and structural measures and cited the critical importance of assuring financial stability through lender-of-last resort actions, financial regulatory reform, and bank recapitalization.

4.  Irrespective of positive economic developments, the BOJ must still work to hit the 2% inflation goal.

•  2% inflation reduces the real value of currently outstanding JGBs.
• More importantly, higher inflation, nominal GDP, and nominal interest rates will restore monetary policy's ability to combat future recessions.  Not only does the zero lower bound place a constraint on monetary policy, but it creates an implied floor on real rates at the worst point in the business cycle when capital investment is already likely to be very weak.  This adds stress on the balance sheets of debt issuers which can reinforce demand sapping deleveraging and financial instability.

Monetary policy measures supported by Abenomics since 2013:

• BOJ announced a new 2% inflation target in January 2013.
• After taking office, Kuroda's BOJ began purchasing both public and private financial assets via quantitative and qualitative easing (QQE).  As a result, the BOJ's balance sheet has ballooned to 88% of GDP.
• Slightly negative policy rates have also been implemented (January 2016).
• In September 2016, "QQE with Yield Curve Control" was initiated whereby the BOJ targets a specific price for long term JGBs instead of purchasing a defined quantity.
• Kuroda also committed to expand the monetary base until the year-over-year inflation rate exceeds and remains above the 2% price stability target (inflation overshoot).

Key economic developments following the implementation of the monetary arrow of Abenomics:

The expansion of the BOJ's balance sheet has coincided with a substantial rebound in NGDP.  Moreover, the unemployment rate has accelerated to do the downside at a time when labor force participation has moved far beyond it's previous peak.  In term of financial conditions, not only has the BOJ successfully managed the yield curve, the yen began to depreciate and the Nikkei broke out to the upside precisely when the monetary component of Abenomics was introduced.  All of this suggests that the BOJ's aggressive monetary policy is working.

Although he acknowledges these improvements, Bernanke laments the fact that 2% inflation has not been reached while the timeline for hitting the target has been pushed back.  One reason for this is that Japan, much like the other major economies, is suffering from a declining and possibly negative equilibrium real interest rate (r-star).  Theoretically, r-star is the real interest rate that corresponds with aggregate demand being equal to potential supply.  If r-star is excessively low or negative, it becomes difficult for monetary policy to bring down the real borrowing rates of firms and households enough to incentivize dissavings.  This causes insufficient demand and an economy producing below potential.

Should such conditions persist, the risk is that expectations of chronically weak economic activity and an associated decline in the return to capital investment can lead to secular stagnation.  Absent an increase in aggregate demand in the domestic economy that restores the return to capital investment, an economy can overcome secular stagnation by investing abroad.  As insufficient domestic demand corresponds with easing monetary policy, this puts downward pressure on the currency.  Capital outflows result in domestic agents accumulating higher yielding foreign financial and real assets.  Essentially, domestic agents fund investments abroad in higher growth areas where capital investment remands highly profitable.  This enables the foreign economy to increase their spending which should inevitably boost global growth prospects. 

Problematically, the global savings glut hypothesis suggests that this mechanism for dealing with the potential for domestic secular stagnation has been blocked as the global desire to save (accumulate assets) has been far in excess of the global desire to invest.  This global imbalance is likely responsible for why major economies are struggling to overcome low interest rate environments.  Rather than finance a greater level of global investment, global portfolio flows are just as likely to excessively bid up existing assets (bubble) and/or fund financially unsustainable consumption.

The secular stagnation argument emphasizes the low return to domestic investment opportunities. For Japan, capital outflows have been an important alternative use of domestic saving. In principle, such outflows should afford Japanese savers higher returns, while also weakening the currency, promoting exports, and maintaining full employment at home. Of course, Japan’s ability to benefit by this mechanism is limited by the extent that other major economies are suffering from slow growth and are themselves contending with the effective lower bound on interest rates. Ideally, Japan’s excess savings not absorbed by other major economies would flow to capital-poor emerging markets, but this channel is narrowed by the global savings glut and policies aimed at promoting trade surpluses and reserve accumulation in many countries. Other factors that block the foreign-investment safety valve and thus depress r-star in Japan include the strong home bias of Japanese savers; international political constraints on the size of the country’s export surplus; pricing-to-market behavior by Japan’s exporting firms, which reduces the elasticity of exports to changes in the exchange rate; and the yen’s status as a safe-haven currency, which means that it tends to appreciate at times of global economic, financial, or political stress.

Therefore in the presence of a global savings glut, according to Bernanke the central bank must either ease financial conditions to the point where domestic demand is revived or generate expectations of increased future inflation.  The hope is that the latter can be achieved by promising to keep rates low even when inflation starts to rise.  However as Bernanke notes, the Japanese public have been relatively unresponsive to the BOJ's communication where inflation expectations have been more sensitive to current developments.  As actual inflation hasn't deviate very much from past inflation, the public's approach has not proven costly which disempowers the BOJ's communication.

A humble critique

With nominal GDP rising and labor markets tightening, Bernanke still somewhat tempers his optimism concerning the BOJ's policy steps because inflation has failed to reach the 2% target.  With the Japanese public's unresponsiveness to Kuroda's inflation directives and financial conditions already very lax, there may be reasons to worry that the central bank's best tools are proving inadequate.  In the future, if the global economy were to experience a very large shock that reinforced potential secular stagnation and global imbalances, one could easily understand how central banks would not be able to overcome such destabilizing conditions.  Thus, it's far too early for the Japanese policymakers to declare anything close to victory.

With all that said, this writer feels that Bernanke overstates the importance of the 2% inflation relative to the nominal GDP target particularly since globalization has ushered in a large positive supply shock.  As stated above, achieving the 2% target would reduce the real value of Japan's outstanding government debt ("reduces the debt burden").  However, irrespective of the inflation trends, improving nominal GDP alone does so as well in two ways.  First, future debt/GDP ratios will be lower as long as denominator increases.  Second, a BOJ that maintains it's inflation goal but fails to hit this mark will either continuously anchor long term JGB rates or end up purchasing a large quantity of future government debt issuance.  Either way, Japan's elusive "fiscal burden" should not be a problem whether or not the inflation objective is actually realized.  In terms of the private sector's balance sheet, rising nominal GDP will increase nominal household incomes, nominal government revenues, and/or rising nominal corporate profits even if inflation remains too low.  This logically should make it easier for the private sector to meet all of their financial obligations.

Importantly, should the majority of future aggregate nominal income end up flowing mainly to one sector of the economy or a concentration of households, under such a scenario where the BOJ achieves their NGDP target, the fiscal authority can always direct resources more broadly.  This likely requires expansionary fiscal policies and BOJ government debt monetization.  Again, accommodating this shouldn't be an issue particularly if inflation and JGB rates remain subdued.  Direct government transfers complimented by monetary accommodation is arguably a better, more direct, and less intrusive way of ensuring that nominal GDP remains on the desired path especially compared to having the government pressure firms into wage and price increases. 

Bernanke rightfully emphasizes this policy channel.

Whether it chooses to engage in an incomes policy or not, the government must still ensure that aggregate demand is sufficient to sustain higher wages and prices. Assuming, again, that we are several years down the road and inflation has not returned, how could that be done?  When central bank action on its own reaches its limits, then fiscal policy is the usual alternative.  However, in Japan, even fiscal policy may face constraints, resulting from the high debt-to-GDP ratio that already exists in Japan. This leads, inevitably I think, to discussions of coordination between monetary and fiscal policy. There are many ways such coordination could be implemented, but the key elements of a possible approach are that (1) the government commits to a new program of spending and tax cuts and (2) the central bank promises to act as needed to offset any effects of the program on the path of Japan’s ratio of government debt to GDP.

He goes on to mention how a nominal GDP target can more likely be achieved as long as there is no expectation of a monetary offset.

In the context of my proposal, however, it may not be necessary for the public to believe the central bank’s claim that it will allow an overshoot of inflation; it may only be necessary that the administration and the legislators believe it. Presumably, a key reason that a government might not approve an expansionary fiscal program at a time when it is warranted by macroeconomic conditions is concerns about the resulting buildup of the national debt. If legislators believed that monetary policies would be used to offset that buildup, they might be more willing to act. Moreover, they would understand that monetary policy would not lean against the expansionary fiscal actions, increasing the multiplier and providing more “bang for the buck.” So the purpose of monetary-fiscal coordination as I’ve described it is not to augment a given fiscal program with central bank promises—or not only to do that—but rather to make the fiscal program politically feasible in the first place. Of course, to the extent that the central bank honors its commitments to allow a temporary overshoot of its inflation target, the impact of the combined program would ultimately be all the larger.

Moreover, if the BOJ is explicit that any coordination is only predicated on the desire to achieve their inflation and/or nominal GDP objectives, central bank independence should remain intact.  Central bank independence is only jeopardized when monetary policy is used to enable policies that are inconsistent with their mandate.  The latter is simply not the case today in Japan and arguably in much of the developed world since nominal GDP growth and inflation remain subdued. 

Bernanke concludes with the following final remarks:

If all goes well, the BOJ’s current policy framework may yet be sufficient to achieve the inflation objective. We’ll have to wait and see. If not, there are relatively few options available. The most promising possibility—should we get to that point—is more explicit coordination of monetary and fiscal policies. Monetary policy that is aimed at limiting the impact of fiscal expansion on the government’s debt could both make fiscal policymakers more willing to act and increase the impact of their actions. The BOJ may be reluctant to take such a step. In the possible future state that I am contemplating, however, there would be no real alternative other than to abandon the fight to raise inflation and, perhaps, even to accept a new bout of deflation. After such a long and valiant effort to end deflation and raise interest rates from their effective lower bound, that would be a most disappointing outcome.

Although it can be argued that Bernanke overemphasizes the benefits of inflation for the reasons mentioned previously, it would certainly prove disappointing if the BOJ and Abe gave up on their joint pursuit of enabling higher levels of future nominal GDP.  Abandoning this worthy goal would be even less defensible giving that the costs of too high inflation are unlikely to take hold anytime soon.  In an economic environment of low growth, inflation, and interest rates, the greater risk is not doing enough of what is already working. 

Overall, Some reflections on Japanese monetary policy is absolutely worth reading (or listening to) not only for monetary policy enthusiasts, but for anyone concerned with how future policy is likely to evolve in a world marred by mixed, uneven, and disappointing economic growth.