Central banks, inflation, currency wars and the Japanese experiment

The following is an abbreviated version of a post from 31 Oct 2014 at Credit Writedowns Pro

Coming on the heels of the US Federal Reserve’s announcement that it would stop expanding its balance sheet with large scale asset purchases, the Bank of Japan’s announcement was music to the ears of Japanese equities investors. And shares in Japan promptly rose 4.8% on the news. The larger question, however, is whether QE is effective either at shaping future inflation or inflation expectations or at increasing nominal and real GDP. The evidence is equivocal. And so Japan presents a unique opportunity to see the limits of monetary policy tested.

Before I go into the Japanese experiment, I want to note that we got two bits of inflation news today. In the US, the Wall Street Journal noted that inflation has undershot the Fed’s 2% target for a 29th straight month with the release of data on personal consumption expenditures. And the PCE was weak even so, with the real number advancing a mere 1.8%. Nominal spending growth then is extremely weak.

PCE inflation

I also noted this morning that market-based measures of inflation like the 5-year TIPS breakeven have been declining throughout the QE3 program:

5 year breakeven

In Europe, inflation picked up to 0.4% from 0.3% in the Eurozone, which is positive news if you want to call it that, given the worry about deflation in the Eurozone.

With the consumption tax increase causing household spending to fall for six months on the trot and with oil prices having plummeted, the Bank of Japan must be panicked because inflation and inflation expectations are now receding, even in Japan, where we have been told the battle against deflation had been won by monetary stimulus. It hasn’t. And so the BoJ is now buying more assets.

the BOJ’s board voted 5-4 to accelerate purchases of Japanese government bonds so that its holdings increase at an annual pace of 80 trillion yen ($723.4 billion), up by 30 trillion yen.

The central bank also said it would triple its purchases of exchange-traded funds (ETFs) and real-estate investment trusts (REITs) and buy longer-dated debt, sending Tokyo shares soaring and prompting a sharp sell-off in the yen.

“Japan’s economy continues to recover moderately as a trend and it’s expected to keep growing above its potential,” the central bank said. “But weak domestic demand after the sales tax hike and sharp falls in oil prices are weighing on prices.”

The Japanese Yen is now at a 7-year low against the dollar as a result.

Let me cut to the chase here. These are extreme measures and extreme levels of central bank intervention into the economy to get it to respond. The BoJ has implicitly set a nominal GDP target by setting a 2% medium-term target on inflation with the residual being real GDP. So clearly the BoJ wants real GDP to increase. And thus this is about as close as you are going to get to the vaunted NGDP target monetarists bang on about. Yet, we are seeing the BoJ have to extend its medium-term time frame to three years instead of two because it will not be able to lift inflation to the 2% level quickly enough, even with the draconian policies it has implemented.

That tells you something.

What I am seeing is failure. Central banks are trying as hard as they can to get their economies lifted up. And yet they seem as far from their goal of higher real growth and higher nominal GDP as ever. In any event, we will have to wait longer to see how this experiment is playing out. It is getting the Yen down and stocks up. They’re at a 7-year high. But right now, I would say the Japanese experiment is failing.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.