Monday, February 4, 2013

Japan and the monetary policy debate

The ongoing monetary policy debate has its origins in Japan and its extraordinary, nearly two-decade long deflationary conditions. Now that Japan-like conditions pervade economies on both sides of the Atlantic, the search for policies that can restore growth when a country faces deflationary liquidity trap conditions and interest rates have touched the zero-bound has become the central question in modern central banking.

Conventional monetary policy loses traction in these conditions, forcing central banks into following unconventional quantitative easing policies. They involve leveraging the central banks' balance sheet to purchase securities of varying types and maturities and thereby inject liquidity into the markets. Central Banks across developed countries have been following this script over the past four years. The BoJ has so far resisted pressures to join this monetary accommodation bandwagon.

The Bank of Japan (BoJ) finally bowed to political pressures and the prevailing conventional wisdom on monetary policy making in its latest attempt to pull the economy out of a deep deflationary trap. It has announced the revision of its short-term inflation target to 2% from 1% and pledged to buy government securities in increased quantities, by renewing and expanding a bond-buying program that expires at the end of the year, to achieve that target. As part of this, after its current Y 101 trillion asset purchase program ends in January 2014, the BoJ proposes to buy Y13 trillion ($146 bn) in short-term government securities each month till it meets its new inflation target

It therefore follows the path of the US Federal Reserve (Fed) and the European Central Bank (ECB) in engaging in quantitative easing to achieve nominal anchors. Though the other two have committed to undertake "limitless" QE, the BoJ has so far refrained from going down that path. Furthermore, as the FT wrote, the details of how it proposes to achieve the 2% target is vague and does not appear to be credible enough to achieve its inflation objective,
But many analysts noted what it did not do: expand the scope of this year’s bond-purchase plans; raise the limit on the maturities of the bonds it buys beyond the current three years; or cut the interest rate it charges commercial banks for overnight borrowing. All had been suggested as steps it might take in pursuit of the new inflation objective... It left its forecast for rises in benchmark consumer prices in fiscal 2013, which begins in April, unchanged at 0.4 per cent. For the following year, it nudged its prediction up by one-tenth of a point to 0.9 per cent.
All this means that the BoJ itself does not believe that its policies will achieve the revised inflation target. It also gives the impression of a central bank stonewalling the perceived assault on its autonomy, despite the apparent ineffectiveness of its policies and the dominant current sweeping central banks across the world. It makes further political pressure on the BoJ to do more to reflate the economy inevitable.

In fact, it looks increasingly certain that Shinzo Abe will have the last laugh, since the tenure of the current Governor and his deputies ends in April this year and will most certainly be replaced with more accommodative candidates. The markets will then perceive that the BoJ's autonomy has been compromised. But the BoJ will have none but itself to blame for not showing the minimal political nous necessary to acknowledge the reality that monetary policy, especially in such times, is a deeply political decision. Its intransigence left the Shinzo Abe government with no choice but to force the BoJ to fall in line.

This follows an aggressive push by the new Shinzo Abe government, which has already initiated a 10 tillion Yen ($112.8 bn) fiscal stimulus program. The program is aimed at boosting growth by 2 percent and runs the risk of aggravating Japan's already high debt-to-GDP ratio of 220%. The Japanese government has already spend 60 trillion Yen on stimulus programs till date. Since the funds for the latest stimulus program will have to come by issuance of government bonds, it is certain to weaken the yen against the dollar and thereby also contribute towards improving the competitiveness of Japanese firms.

In this context, long-time Japan expert, Adam Posen has raised doubts about whether Japan requires another round of fiscal stimulus. He argues that Japan's big problem is deflation and over-valued exchange rate, which can be addressed through higher inflation target and more aggressive quantitative easing, and more fiscal spending would only add to the country's public debt burden.

But Paul Krugman points to a recent paper by  Paul McCulley and Zoltan Pozsar who argue that in Minsky-like cycles of leveraging and de-leveraging, monetary policy can be effective only when it is paired with fiscal stimulus. They write,
What matters is not monetary stimulus per se, but whether monetary stimulus is paired with fiscal stimulus (otherwise known as helicopter money) and whether monetary policy is communicated in a way that helps the fiscal authority maintain stimulus for as long as private deleveraging continues. Fiscal dominance and central bank independence come in secular cycles and mirror secular private leveraging and deleveraging cycles, respectively. As long as there will be secular debt cycles, central bank independence will be a station, not a final destination. 
In any case, apart from the pursuit of inflation, such competitive debasement of currency will also affect have repercussions in the foreign exchange markets. Aggressive quantitative easing and resultant liquidity injections will inevitably put downward pressure on currencies. It is now widely accepted that the Fed's QE has contributed in no small measure to depreciating dollar and increased American export competitiveness.
Trade-weighted basis
A weaker currency with its positive impact on exports is likely to provide governments with an irresistible temptation to indulge in competitive devaluations. In Japan, the appreciation of yen in recent years has caught the attention of the new Prime Minister Shinzo Abe, who has even called upon the central bank to target an exchange rate of 90 yen to a dollar. This has prompted Jens Weidmann, Bundesbank President, to caution against the trend of central banks losing autonomy and their decisions getting politicized. In particular, he warned about potential "currency wars", as governments force central banks into devaluing their currency to boost exports.

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