By David Llewellyn-Smith, founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. Originally posted at MacroBusiness
There’s a chart that lends a certain urgency to the Bank of Japan’s (BOJ) monetary policy meeting late this month. It is this one of the yen:
Ever since the BOJ announced a new negative interest rate policy earlier this year (NIRP) the yen has stopped falling and reversed upwards. That is, despite weak Japanese growth, despite an inverted yield curve and deeply negative long bond, and despite still weak inflation, markets have bet on spectacularly easy monetary policy generating even more of all four. This is what is know as “quantitative failure”, the notion that negative interest rates will not expand the monetary base owing to such phenomenon as crushed bank margins and the hoarding of cash under mattresses, so the currency is therefore going to rise.
This is because Bank of Japan governor Haruhiko Kuroda is now looking for a new alternative form of monetary easing, given he has probably reached the practical limits of responsible JGB buying, as already discussed, while his initial move to impose negative rates in January led to the opposite market reaction than expected (ie, a stronger yen and a weaker stock market, see Figure 8) while also proving politically very unpopular. This probably explains why Kamikaze Kuroda has not expanded the negative rate policy further since January even though inflation and inflation expectations have moved in the opposite direction of what he has been targeting.
The latest data will make it harder for Kuroda to do nothing at the next BoJ policy meeting due to be held on 28-29 July given the stress he has put on monitoring inflation expectations. That is unless he just admits he has failed!
Given the unattractive options of buying still more JGBs or ETFs, or risking an undoubtedly unpopular expansion of negative rates, Kuroda and indeed Abe will be looking for a new approach. Monetisation of infrastructure stimulus may be the option.
Meanwhile, in an effort to calm potential concerns about the integrity of the fiscal budget central bankers implementing such a future monetisation of infrastructure spending will doubtless be at pains to describe the process as a “one off” though, as the ever theoretical Bernanke stated in his blog: “To have its full effect, the increase in the money supply must be perceived as permanent by the public.”
…a policy of “helicopter money” is only likely to work if it is done on an ongoing basis and in continuing and growing amounts. But at that point the risk of a policy mistake grows exponentially, in terms of a potentially destabilising pickup in inflation expectations and a related pickup in velocity.
Japan may well pick this moment to experiment further with monetary debasement. Just as China has used the post-Brexit environment to accelerate its yuan devaluation, Japan is in a better position than it was a few months ago to try something new after what was a rather cross G20 meeting in Shanghai that swore off competitive devaluations.
There is some other movement around the place to support a renewed Japanese monetary experiment. Ben Bernanke will visit the BOJ and Prime Minster Shinzo Abe this week, from Reuters:
Senior Japanese policymakers will discuss global market developments on Friday and former Federal Reserve Chairman Ben Bernanke will have talks in Tokyo next week with officials including Prime Minister Shinzo Abe, government sources said.
…Bernanke, who led the Fed through the global financial crisis in 2008, will be in Japan next week. It has been arranged for him to meet officials including Abe and Bank of Japan Governor Haruhiko Kuroda, according to a government official speaking on condition of anonymity.
Bernanke is expected to discuss Brexit and the BOJ’s negative interest rate policy with Abe and Kuroda, the official said.
Some market players speculate Kuroda might decide, in a surprise, to provide “helicopter money” – a term coined by American economist Milton Friedman and cited by Bernanke, before he became Fed chairman, when talking about how central banks might finance government budgets as a way to seek to fight deflation.
As well, Larry Summers wrote late last week in the Washington Post:
The Fed-funds futures market provides a window into market thinking regarding the likely path of monetary policy. Remarkably, the market does not now expect a full Fed tightening until early 2019. This is despite all the Fed speeches expressing optimism about the economy and a desire to normalize interest rates.
I believe these developments all reflect a growing awareness of the importance of the secular stagnation risks I have highlighted over the last several years. There is a growing sense that the world is demand-short — that the real interest rates necessary to equate investment and saving at full employment are very low and often may be unattainable given the bounds on nominal interest rate reductions. The result is very low long-term real rates, sluggish growth expectations, concerns about the ability even over the fairly long term to get inflation to average 2 percent, and a sense that the Fed and the world’s major central banks will not be able to normalize financial conditions in the foreseeable future.
Having the right worldview is essential if there is to be a chance of making the right decisions. Here are the necessary adjustments:
First, with differences between countries, neutral real interest rates are likely close to zero going forward. Think about the U.S., where growth has been relatively robust by recent standards. Growth has averaged little more than potential for the last one, three or five years while the real Federal funds rate has been about -1 percent. There is no good reason to think given sluggish investment expectations that the neutral rate will rise to be significantly positive in the foreseeable future. The situation is worse in other countries with more structural issues and slower labor-force growth. Substantial continued reductions in Fed estimates of the real neutral rate lie ahead.
Second, as counterintuitive as it is to central bankers who came of age when the inflation of the 1970s defined the central banking challenge, our problem today is insufficient inflation. In the U.S., Europe and Japan, markets are now expecting inflation that is below target even with full employment over the next 10 years. This is despite a 70 percent rise in the price of oil. Evidence from markets and some surveys suggests that inflation expectations are becoming unhinged to the downside. The policy challenge with respect to credibility is exactly the opposite of what it has been historically — it is to convince people that prices will rise at target rates in the future. This is likely to require some combination of very tight markets and mechanisms that give confidence that during the best times, inflation will be allowed to exceed target levels so that over the long term, they can average target levels.
Third, in a world where interest rates over horizons of more than a generation are far lower than even pessimistic projections of growth, traditional thinking about debt sustainability needs to be discarded. In the U.S., the U.K., the Euro area and Japan, the real cost of even 30-year debt will be negative or negligible if inflation targets are achieved. Indeed, the conditions Brad DeLong and I set out in 2012 for expansionary fiscal policy to pay for itself are much more easily satisfied today than they were at that time.
Fourth, the traditional suite of structural policies to promote flexibility are not especially likely to be successful in the current environment, though some structural policy approaches such as removal of restrictions on investment are still desirable. Indeed, in the presence of chronic excess supply, structural reform has the risk of spurring disinflation rather than contributing to a necessary increase in inflation. There is, in fact, a case for strengthening entitlement benefits so as to promote current demand.
These are the monetary titans of our times shifting radically towards various new forms of stimulus. Resistance to them is likely still to be strong on Western economic institutions but it is Japan that has led the world into the deflationary era and it is in Japan that the next phase of monetary innovation is likely to be pioneered.
Australian investors need to bear this mind because if Japan were to move to the direct monetary financing of infrastructure so soon after its NIRP experiment then the same will follow to other countries as some stage. The implications are:
- the yen ought fall given it is a resumption of the expansion of the monetary base;
- that will, in turn, defeat Japan’s reflationary goals given it will weigh on commodity prices;
- however, if, in the longer run, probably after the next global shock, such policies were to be adopted on a widespread basis then it could well be good for commodity prices given the forex effects would net out and demand rise for building materials;
- this could present an especially attractive solution to Europe – if the Germans could get over themselves – given it could finance all kind of modernising investments in its weakest and most troubled states, finally offering a carrot as well as stick to structural reform foisted upon them from the core, and taking pressure off governments from secessionist movements.
I don’t think that small markets like Australia could ever do it, just as none has done QE, given the currency impacts could be enormous. So I don’t think it has much relevance to the current national discussion about twin deficits and sovereign ratings. But if it were to be adopted in the major economies it would not necessarily need to be taken up here anyway given we’d directly benefit from the commodity price spillovers.
The bottom line is that the helicopter monetarists are right and the sooner the world moves to a new form of ‘deleveraging stimulus’ the better.