NNIP: Ein Schritt näher hin zu "helicopter money"

To understand the background of the Bank of Japan’s “Comprehensive Assessment” we have to bear in mind that – at least in the perception of investors and maybe the Japanese public – there has been a structural break in the reaction function of the Japanese central bank early this year. Such a structural break actually also occurred in early 2013 in a dovish direction. Before that time, the leadership of the pre-Kuroda BoJ believed that deflation was a phenomenon dictated by the shrinking supply side of the Japanese economy and that there was little that the central bank could do about this. This defeatist attitude towards deflation runs counter to most macro-economic theories, even those theories that otherwise suggest that government intervention is neutral at best and harmful at worst (well, these theories do always suggest that deregulation and lower corporate taxes are a good thing which in my view is also a form of government intervention but that is a story for another day).

The price level, or its first derivative with respect to time aka the inflation rate, is almost universally accepted to be a purely monetary phenomenon in the long run when the economy has digested all shocks to its real side. “Inflation is always and everywhere a monetary phenomenon”, as Milton Friedman famously put it. Hence, in the end deflation is a choice to remain stuck in a secular stagnation-like equilibrium where depressed nominal growth expectations create their own reality on the demand side via a high net savings appetite and on the supply side through sluggish productivity growth.

Shinzo Abe and Haruhiko Kuroda basically took this message on board and set out to push the economy towards an equilibrium with positive nominal growth expectations where the nominal side of the equation is centred on an inflation target of 2%. The experience over the past 3.5 years shows that this is easier said in theory than done in practice. Still, the start of the new BoJ reaction function was very promising. The essence of this reaction function was an aggressive and pre-emptive monetary policy response to overheat the economy and push inflation expectations higher towards the target. The overheating part is essential in this story because inflation tends to settle around the expected rate of inflation when the output gap is closed and all shocks (oil prices, exchange rate, etc.) have been digested. Hence, unless the private sector immediately deems the new inflation target fully credible, inflation expectations will only start to rise if actual inflation has been above the expected rate for some time.

The initial success of the new monetary policy strategy was evident in the sharp depreciation of the yen, the rise in market- and survey-based inflation expectations, the increased incidence of price increases in the basket of daily purchases, the rising trend in core inflation, the moderate uptrend in core wage growth, the surge in profits and the sharp tightening of the labour market. Initially, consumer spending also played its part but the 2014 VAT hike killed that engine off until recently, as we see some uptrend in the level of consumption again. Meanwhile, corporate savings remained relatively high throughout the entire period. Nevertheless, until early this year, the BoJ did indeed react without hesitation to defend what was gained in terms of rising inflation and inflation expectations as well as a weakening yen and to enhance these trends further.

Change to a less aggressive reaction function

Still, after the January easing announcement which featured the introduction of Negative Interest Rate Policy (NIRP) something happened on the way to Japanese reflation heaven. The BoJ reaction function seems to have changed from aggressive and pro-active to hesitant and even paralysed. There are probably several reasons behind this.

First of all, even though in theory monetary policy can achieve any inflation rate desired, in practice the central bank does face some constraints. Over the past year or so, DM central banks which have applied enhanced forward guidance about the policy rate, NIRP as well as sovereign QE have experienced that there are diminishing returns to these instruments. This holds especially to the extent that other policy levers (mainly fiscal) do not cooperate sufficiently towards the aim of achieving sustained positive nominal growth. In addition to this, the external environment can act as a constraint as well. For instance, if your main trading partners are in the same situation (monetary policy at the zero lower bound, excess savings etc.) it is difficult to gain additional monetary traction via currency depreciation. The essential consequence of insufficient cooperation from other policy levers and the external environment is that this will push r-star lower than it would have been otherwise. Next to this, the marginal response of private spending to a decrease or flattening of the yield curve is likely to fall once curves are already very low and flat. One very important reason for this is that low and flat curves reduce bank profitability which could have adverse consequences for credit supply. Finally, lowering rates when they are already low may lead to a political and/or public opinion backlash and even the most independent central bank will be sensitive to this.

A second reason why the BoJ’s reaction function has changed could be that Kuroda wanted to enhance and signal monetary dominance over fiscal policy. In this respect, he “forced” fiscal policymakers to move first by announcing their fiscal easing plans to prevent them from under-delivering, which might have happened if the BoJ had moved first. In a sense that is a clever strategy for the medium term, because the effectiveness of monetary policy will benefit from the rise in the neutral real policy rate.In addition to this, it is not inconceivable that at some point in the future the BoJ will have to semi-permanently monetize at least part of the sovereign debt stock. This could be done by promising to keep Japanese government bonds on its balance sheet for years, if not more than a decade. As we have argued before, this comes very close to helicopter money (financing fiscal deficits by printing money) which is ultimately a very radical monetary policy tool but one that does ensure that the BoJ will be able to reflate successfully. Both theory and history show that helicopter money is an assured way to push actual and expected nominal growth towards a permanently higher path. In practice, this often led to governments to overindulge big time which eventually resulted in hyperinflation.Monetary dominance is then very important to prevent overshooting into a high inflation equilibrium. The central bank should always have complete control over the amount of helicopter money to be used and this amount should be fully determined by its price stability mandate.

A step closer to helicopter money

There was not so much new easing at the BoJ’s last meeting, but it is in our view significant change in the policy framework that will enable future policy easing to reach the target more sustainably. The first innovation is yield targeting, whereby longer-term bond yields are anchored around 0%. The cost of this policy is more volatility in the expansion of the monetary base in the short run. The positive side is that it may relieve some of the adverse effects of the negative interest rate policy on banks´ profitability by pushing yields above 10 years higher while further reducing shorter-term yields. This of course only works if the slope of the yield curve rather than its level is the most important driver of financial sector profitability. To a first order approximation this seems correct, but there is a little caveat here: To the extent that retail deposit rates cannot fall below zero, the level of the short-term yield curve matters as well. The underlying idea is that private spending as well as the yen exchange rate are likely to be relatively more sensitive to short-term yields while pension fund and insurance returns as well as the return on part of the non-loan book assets of banks depends more on longer-term yields. This will hold especially if a moderate rise in the latter goes alongside an increase in confidence which boosts risky asset prices. Credibility will be an important issue. The more credible the 0%-target is, the less the BoJ will have to intervene.

The second innovation is the change in forward guidance. Policy accommodation will continue until there has been a target overshoot for some time. This brings Japanese QE a step closer to helicopter money. The balance sheet of the BoJ will not shrink within the private sector planning horizon. Such a commitment is entirely reasonable. After all, a 2% target implies that actual inflation should be equal to 2% on average in the long run. The BoJ has undershot the target since the inception of Abenomics in 2013 so an overshoot is exactly what the doctor ordered. 

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