is the cause of Japan's ongoing deflation? Can a theoretical framework
explain these developments? If so, can the Bank of Japan (BOJ) "create
inflation at will" as many have argued?
country has suffered from deflation for five consecutive years,
measured by the consumer price index (CPI), and low inflation for
almost a decade. On a QoQ basis, Japan's headline series indicates
a deflationary downtrend for 18 consecutive quarters, whereas "core"
inflation (i.e., CPI excluding fresh food) has showed a smaller
rate of decline in the past three quarters. However, this "core"
deceleration was mostly due to inflationary changes in the cost
of education, personal care services, cigarettes, and other miscellaneous
items. Other categories, such as utilities, housing, household utensils,
clothing and medical care have shown smaller decreases.
in the GDP Deflator, considered to be a much broader measure of
goods and services in Japan, have been much steeper. In 1Q 2004,
the GDP deflator fell 2.6% YoY, bringing its deflationary downtrend
to 24 consecutive quarters. The rate of decline was almost unchanged
from 4Q 2003, when it was -2.7%.
is the cause of Japan's on-going deflation and mild-level inflation?
Monetarists, led by Nobel Laureate Milton Friedman, argue that "inflation
is always and everywhere a monetary phenomenon"—something
that is directly controlled by the central bank (in this case the
BOJ) through a "stable" monetary policy using open
theory behind what impact open market operations may have depends
largely on one's interpretation of why we hold money in the first
place. One famous theory is expounded by John Maynard Keynes' liquidity
preference theory. According to Keynes, people hold money for more
than just transactions (the classical view); they hold it for speculative
reasons. The three panels below illustrate how the BOJ's open
market purchases should theoretically affect interest
rates, loanable funds, output—and by extension, prices.
Empirical findings will follow the theory2
left panel shows how monetary policy works through an open market
purchase, where an initial equilibrium at point "i0,"
the nominal interest rate, exists for the demand and supply of money
("D" and "S0", respectively).
If the BOJ were to conduct an open market purchase (i.e., quantitative
easing), government bonds, bills or repos are purchased with the
BOJ's created cash; the nominal quantity of money
injected into the economy, therefore, increases; and the left panel
shifts to the right from "S0" to "S1."
Assuming the demand for money (liquidity) remains unchanged, the
nominal interest rate (the price of money) should fall from "i0"
to "i1" as the general public will be prepared
to hold less in bonds (now held by the BOJ) and more in cash. Supply
(money) exceeds demand (interest, bonds), so nominal interest rates
(and bond yields) should theoretically fall.
the BOJ purchases these bonds, the cash received by the public tends
to be deposited in the banking system. This increases the
reserves of the banking system and, through the deposit expansion
multiplier, increases the supply of loanable funds in the Japanese
economy. This is depicted in the middle panel as rightward shift
of the supply curve for loanable funds from "S0"
to "S1." If the demand for funds remains unchanged,
real interest rates should decline from "i0"
real interest rates decline, real aggregate demand is stimulated
in three ways: (1) by current investment and consumption becoming
cheaper relative to future spending , thereby inducing a short-term
catalyst; (2) by lower real returns (yields) on financial assets
removing incentives for foreigners to invest in Japan, which, in
turn weakens (depreciates) the Japanese yen, thereby stimulating
exports; and (3) by asset values rising to produce a "wealth
effect" that stimulates more spending on goods and services
(the bond, stock, and housing markets respond favorably.)
increased demand for goods and services moves the aggregate demand
curve in the far right panel to shift upward from "AD"
to "AD1." If the BOJ's bond purchases (monetary
easing) was not anticipated by the public, the short-run aggregate
supply curve, or SRAS, will not change. Consequently, the economy
will expand along the SRAS curve as real GDP and employment increases
from "Y0" to "Y1," and
the general price level increases from "P0"
to "P1." Put differently, as the economy expands,
so does the demand for goods, services and resources; demand exceeds
supply, and therefore prices will go up (inflation).
theory is the more extended monetarist principle first expounded
by economist Irving Fisher. Known as the quantity theory of
money, MV=PY—money (M) * velocity (V) = prices (P)
* output (Y). If you raise M, then P will rise too. And since prices
(P) are linked to nominal GDP (Y), if you raise M you also raise
Y 3 . Simple.
is it? Should basic monetary theory prove correct, Japan's so-called
"lost decade" of deflation, declining demand, rising unemployment
and low output could (and should) have been corrected with an aggressive,
but clearly stated, monetary policy by the BOJ.
facts show that the BOJ has lowered discount rates (collateralized
overnight call rates) from a post-bubble high of 8.3% in March 1991
to virtually zero in June 2004. It has also begun, somewhat belatedly,
an aggressive quantitative easing of its so-called high-powered
money, or base money, in the 2000-2002 period (see chart below).
The latter move forced nominal interest rates to fall completely
to zero by 2002. Since then, annual base money growth slowed down
further in June 2004 (3.2%), marking the fourth consecutive month
of deceleration. Growth rates of both the current account balance
and bank notes continued to decelerate as well; annual growth of
bank notes fell to 1% yoy in June 2004 for the first time in 13
faces a "liquidity trap," where short-term nominal discount
rates are zero, but people continue to hoard money rather than consumer
or invest. Against this backdrop, the BOJ argues that it does not
have the necessary instruments to achieve inflation in the current
liquidity trap environment.
certainly looks that way.
we mentioned earlier, theory dictates that any expansion of the
monetary base should lead to money multiplier affects. In other
words, by purchasing government bonds the BOJ and the general public
(via city and regional banks) enter into an agreement to increase
the BOJ's reserves, to increase deposits of the banks for which
loanable funds become available, which in turn should re-enter the
bank through more bank deposits by the loan applicant, and so forth.
But empirical evidence demonstrating this theory has produced mixed
has been very little significant impact on the growth of broad money
(M2+CDs) or the broadest liquidity (M4+CDs)—largely considered
to be representative of the "money supply" in Japan. As
the chart below indicates, although growth of broad money did pick
up slightly in 2001, the move basically reflected a shift out of
postal savings deposits because of the maturation of long-term teigaku
deposits, and this effect has since passed. This is a clear
departure from the 1980s and early 1990s, when the correlation with
base money was much tighter. Since 1993, the growth rates have progressively
the money multipliers, with respect to both M2+CDs and M4+CDs, have
fallen steadily since the mid-1990s (see chart below). Money multipliers
no longer "multiply."
Figure 1 indicated, there is a sizeable disconnect between the CPI
and the GDP deflator in recent months. While both are still in negative
territory, both indexes tended to move in unison throughout the
1990s. If there is a chance of re-inflation, does the market anticipate
it? And how does the BOJ react to this information?
critics of the BOJ have argued that it should adopt an explicit
inflation target. This would involve specifying a target range for
the inflation rate and a time period for achieving the target. Countries
such as Australia, New Zealand, the UK and Canada are all currently
employing such targets.
I already mentioned, the BOJ has consistently counter-argued that
it does not have the necessary instruments to achieve an inflation
target in the current liquidity-trap environment with a floating-exchange
rate regime. Rather, it has "committed" itself to maintaining
its current policy stance of quantitative easing until prices have
turned "positive" as measured by the core CPI—although
BOJ Governor Fukui's meaning is unclear in this instance. What does
"positive" mean? How long must prices remain "positive"
before policy changes? In what form will this change of policy take?
lack of commitment clarity has overshadowed the actions of the bond
market. The questions is: does the market believe inflation is forthcoming?
chart below plots Japan's CPI against various decomposed JGB yield
curves. The theory is that bonds of different maturities are substitutes,
although not necessarily perfect substitutes; the investor may need
an incentive (read: higher interest rate) to part with his/her money
for longer maturities. Inflation risk erodes the purchasing power
associated with such initial bond payments4
. The ensuing "yield curve" demonstrates this principal
by telling us about the public's expectations of future short-term
interest rate movements, and by extension, inflation risk5
bond market movements suggest either a belief in the BOJ's commitment
to price stability or an optimistic view that inflation is around
the corner, depending on the time-frame. A steeply rising yield
curve, say, from May-October 2003, suggests that short-term interest
rates are expected to rise. At its low in May 2003, a 10-year JGB
had a yield 0.54 percent (its lowest in recent years), while a 5-year
JGB and 2-year JGB had yields of 0.16 percent and 0.05 percent,
respectively. Effectively, the market continued to believe that
the BOJ's current "wait and see" policy of inflation through
quantitative easing would take place. By October 2003, 10-year JGBs
had risen to 1.46 percent and 5-year and 3-year yields had risen
to 0.64 percent and 0.155 percent, respectively. These yield increases
imply not only the possibility the BOJ would slow monetary easing
(so-called tightening), but rather quickly judging from the 48bps
(5-year) and 10bps (2-year) moves of the JGBs!
post-October 2003 yield slope movements (moderately steep vs. very
steep yield curves) suggest that the market is no longer sure that
inflation is imminent. If anything, deflation may persist.
Deflation Persists, The Theories
has gone wrong? Why does the market believe that deflation may persist?
There are several competing theories. First, the direct link of
base money growth to bank lending via the reserve requirement (see
The Theory) clearly is not working. Money multipliers are not "multiplying.":
Obviously, the sheer size of predicting outcomes in the whole economy
is different from any agreement one may find among micro-economists.
Still, several economists have floated theories as to why
the assumptions behind the affects of monetary policy have yet to
deliver inflation. The top-5 post hoc explanations include:
Nominal interest rates may be zero, but there are few profitable
investment opportunities in post-bubble Japan that could induce
businesses to borrow or banks to lend. Structural reform and deregulation
are needed. Richard Katz has adopted this view.
Nominal interest rates may be zero, but real interest rates (nominal
interest rate minus rate of inflation) are still hindering growth.
The BOJ needs to announce a inflation target and print enough money
to meet such expectations in order to meet such a general price
target. Paul Krugman has expressed this view.
The disconnect in growth between M1 (currency + deposits) and M4
(broad liquidity) indicates a malfunction in the transmission mechanism.
The BOJ may have expanded the money base in the 2000-2002 period,
but the monetary easing was not aggressive enough. Some Tokyo market
economists have expressed this view.
Deflation is the result, not the cause, of a spiraling market psychology
aimed at cleaning-up highly leveraged balance sheets. No level of
monetary easing or inflationary targeting will convince businesses
to use their free cash flow for investment rather than debt-reduction.
Richard Koo has expressed this view.
Nominal zero interest rates cannot expect to be helpful if bad debt
prevents banks from lending and if the central bank does not increase
its credit creation to compensate. For bank credit creation to rise,
banks' risk aversion needs to be lowered. This can be achieved if
the central bank were to conduct a one-off write purchase operation
of all declared bad debts from the banks at their original book
value. Richard Werner has expressed this view.
Milton Friedman's famous 1956 article, "The Quantity Theory
of Money: A Restatement" expanded upon both Irving Fisher's
quantity theory of money (i.e., M*V=P*Y) and John Maynard Keynes's
liquidity preference theory. The reason people hold money, Friedman
argued, were the same reasons why people demand any asset. His theory,
known as the portfolio choice to money, indicated that the demand
for money should be a function of the wealth of the individual and
the expected returns on other assets relative to the expected return
on money. However, unlike Keynes's theory, which indicates that
interest rates are an important determinant of the demand for money,
Friedman's theory suggests that changes in interest rates should
have little effect on the demand for money. Why? Because, in Friedman's
view, any change in expected interest rates effect not on the expected
return on money, but also on other assets as a result of the expected
return on money.
In effect, the ISLM model is the more sophisticated exposition of
the Keynsian liquidity preference theory discussed here. It
was invented by Sir John Hicks in a famous 1937 article, "Mr.
Keynes and the Classics."
The difference is that Keynes abandoned the classical view that
velocity was a constant. This was probably a wise move considering
that the classical monetarist belief in the stability of velocity
is not borne out in the Japanese data; in fact, the velocity of
money (i.e., GDP ÷ the money supply) has been terribly unstable
since the 1970s.
For example, if a risk-free 10-year JGB has a coupon rate of, say,
2.8 percent, and prices increase at the rate of 1 percent p.a.,
the investor's real rate of return will be 1.8 percent. A higher
expected inflation rate results in a further reduction in the purchasing
power of bond payments, thus lowering the demand for bonds. In order
to protect one's investment portfolio, all else being equal, the
bond holders will sell their positions in favor of newly issued
bonds with (hopefully) higher interest rates (As bond prices fall,
interest rates rise. This is the so-called "Fisher effect.")
The "yield curves" in the accompanying chart are nothing
more than the graphic representation of the so-called "absolute
yield spreads," or yield differentials, that exist between
JGBs of different maturities.
first published June 23, 2004.
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