The Bank of Japan’s Moment of Truth
After years of deflation, Japan's labor market is the tightest it has been in decades, and the Bank of Japan is still providing significant stimulus to the economy. But with inflation still well below target, central bankers are finding themselves between a rock and a hard place.
TOKYO – The Japanese economy has enjoyed seven consecutive quarters of positive growth, with the average annual rate reaching 1.9%. With aggregate demand exceeding potential output by 1%, the country’s “GDP gap” is now positive. Unemployment is down to 2.7%, the lowest level since 1993, and the job-opening-to-application ratio is 1.56, its highest level since 1974, resulting in acute labor shortages in several sectors, including construction, retail, and package delivery. And in January this year, the Nikkei Stock Average rose above ¥24,000 ($216), its highest level since 1991.
But, while these indicators suggest that Japan is finally out of the woods of more than two decades of stagnation, deflation, and economic insecurity, the headline inflation rate, at just 0.6%, remains far below the Bank of Japan’s 2% target. And, notably, while the BOJ had been attributing low inflation to falling energy prices, energy is now contributing positively to inflation. When fresh food is excluded from the price index, the rate rises to 0.9%, but falls to 0.3% when also excluding energy.
Considering the current labor shortages, why Japan has not experienced a healthy wage-inflation spiral remains a mystery. To be sure, inflation is also missing in the United States and Europe. But the Japanese case is particularly striking. Japan’s real economy has been supported for years by fiscal deficits as high as 6% of GDP, and by extraordinary quantitative easing (QE), which BOJ Governor Haruhiko Kuroda introduced in April 2013. The debt-to-GDP ratio has since risen to 230%, and the BOJ has assumed ownership of more than 40% of outstanding government bonds (JGBs).
The BOJ has maintained its negative policy rate and 0% ten-year-bond rate by purchasing annually ¥80 trillion in JGBs and ¥6 trillion in equities. But, more recently, it has kept the ten-year-bond rate at 0.0-0.1%, while reducing the pace of new purchases of JGBs to around ¥50 trillion, in what some regard as a stealth tapering.
With Kuroda’s term ending in early April, two camps of critics have become increasingly vocal. The first camp, arguing that the real economy is what matters, wants the BOJ to stop providing stimulus and start worrying about its bloated balance sheet.
When the inflation rate moves closer to the target, the BOJ will have to start raising its policy and long-term rates without adjusting the size of its balance sheet – which is exactly what the US Federal Reserve is already doing. Given the low average coupon rate of asset-side long-term bonds, the upward shift of the yield curve will result in a loss for the BOJ (“negative seigniorage”), at least temporarily. In the worst-case scenario, the BOJ could exhaust its capital and require a fiscal injection, which could jeopardize its independence.
Accordingly, the first camp believes the inflation target should be lowered to 1%. Inflation would then be on target, and the BOJ could wind down its QE program. The major drawback of this approach is that it would cause the yen to appreciate sharply, striking a blow to the real economy.
The second camp believes that more stimulus is needed, and that increasing the consumption-tax (VAT) rate in April 2014 was a huge mistake, as is stealth tapering. Instead, QE and expansionary fiscal policies should remain at full throttle until the 2% inflation target is reached. That means more government expenditure through more JGB issues, to be purchased by the BOJ – also known as “helicopter money.” The problem is that intentionally blowing up the budget deficit will increase the risk of a fiscal crisis down the road, without helping the real economy.
When the BOJ held its latest policy-setting meeting on January 22-23, it maintained the approach it has followed for more than a year. Kuroda and his deputy governors are probably hoping that the real economy’s strong performance will translate into higher inflation soon. But will it?
Generally, three keys to higher inflation are wage increases, resulting from labor scarcity; expectations of higher future inflation among the public; and a favorable external environment.
With respect to wages, Japanese Prime Minister Shinzo Abe’s government has been pressuring major corporations to raise wages by 3% or more. That should be manageable, considering that many corporations are enjoying record profits. And yet unions in Japan remain timid, and workers remain traumatized from 15 years of deflation. As a result, many choose job security over pay hikes. Demanding higher wages, they fear, would give companies an excuse to move operations abroad or adopt labor-replacing technologies.
As for the second ingredient, the BOJ has admitted that it underestimated the difficulty of influencing inflation expectations when it introduced its QE program in April 2013. In Japan, the expected inflation rate, however it is measured, tends to track the actual inflation rate, albeit with some lag. This helps to explain why simply announcing a 2% target has not anchored the public’s expectations, as it has in the US.
At the same time, the external environment is promising. Almost every other advanced economy is experiencing steady, synchronized growth. And emerging economies, especially China, have also regained strength. At the level of the global economy at least, the stars seem to be aligned for inflation to reach the 2% target rate in Japan, the US, and the eurozone.
In Japan, the Phillips curve tends to be L-shaped. Right now, the economy is very close to the kink in the “L,” the point known as the non-accelerating inflation rate of unemployment (NAIRU). Any sign of a vertical move (implying higher inflation with an unemployment rate at NAIRU), rather than a horizontal one (a lower unemployment rate without CPI inflation), will be welcomed by the BOJ, and good for the economy at large.
Misery Loves Inflation Targeters’ Company
Inflation targeting is a means to an end – to facilitate full employment and higher GDP growth – and, at least in Japan, substantial progress has been made toward achieving it. So, if faster price growth, like higher unemployment, implies economic and social costs, why should the Bank of Japan remain obsessed with bringing it about?
TOKYO – The United States, Europe, and Japan are all making positive economic strides. In the US, the unemployment rate is falling, and now stands at just over 4%. Unemployment remains high in the eurozone, at close to 9%, but that still represents significant progress from the past decade or so. And Japan has achieved virtually full employment, with labor demand so high that new graduates are able not just to find jobs, but to choose them.
Yet there is one key area where progress seems to be lagging: inflation. While the US consumer price index reached 2.2% in October, the European Central Bank and the Bank of Japan have so far been unable to meet their targets of roughly 2% inflation, with the eurozone’s average annual price growth hovering around 1.5% and Japan’s firmly lodged in the 1% range.
There are good reasons to strive to meet the inflation target. Money markets would be rid of near-zero interest rates. Concerns about currency appreciation damaging export competitiveness would be assuaged, as globalization and artificial intelligence continue to create competition for workers. And the expansionary monetary policy pursued by the world’s major central banks in recent years would be vindicated.
Yet when it comes to ordinary people’s wellbeing, meeting the inflation target is not always the best option. Of course, reining in high inflation is beneficial, as it preserves the value of existing money. But raising below-target inflation to 2% leaves people worse off, as it causes their savings to lose value continuously, thereby undermining their prosperity.
The late Arthur Okun, who was one of my professors at Yale before serving as Chair of US President Lyndon Johnson’s Council of Economic Advisers, created the so-called misery index, which goes beyond headline GDP growth or the unemployment rate to provide insight into how the average citizen is faring economically. Okun’s index – the sum of the inflation and unemployment rates – is based on the assumption that an increase in inflation, like an increase in unemployment, creates economic and social costs for a country.
The reality is that the inflation target is a means to an end – to facilitate full employment and faster GDP growth – not an end in itself. And, at least in Japan, substantial progress toward that end has been made, despite the failure to meet the Bank of Japan’s inflation target. Signs of full employment in the market for permanent workers could set the stage for a moderate wage-price increase. That was not the case before 2013, when the implementation of Japanese Prime Minister Shinzo Abe’s economic-reform program, so-called Abenomics, ended a period of austere monetary policy.
But this has not deterred critics of Abenomics from harping on the non-fulfillment of the inflation target. The question is why.
Not long ago, I posed that question to a monetary-policy authority (whose name I am not at liberty to divulge). Rather than provide a straightforward answer, he replied that it was “tricky,” finally landing on the statement that, no matter how low the unemployment rate, the inflation target should be pursued.
This kind of thinking is common among economists, particularly the generation swept up by the “rational expectations” revolution in macroeconomics. This cohort views economics as the study of models, in which agents’ expectations can be assumed to be rational and consistent with the model. From this perspective, inflation expectations can be assumed to be either ideal predictions of the future, or at the very least rational ones, with their accuracy and precision undermined only by limitations in information received by economic actors.
Older economists thought differently, assuming that most economic outcomes in the real world are the result of behavior that is at least partly irrational, meaning that expectations should be viewed more as reasonable possibilities than near-certainties. Because I belong to the generation taught by old sages – Lawrence Klein, Franco Modigliani, and James Tobin – I think this is a worthwhile assessment – one that should be applied to today’s discussions about monetary policy and inflation.
While it is important to recognize the merits of inflation targeting, the misery index, too, has a role to play in helping us to assess the state of our economies – and the success of our policies.
Asia’s Central Banks Should Prepare to Raise Interest Rates
In the wake of the global economic crisis, Asia’s central banks, like their counterparts in the advanced economies, took on a leading role in supporting domestic growth. But, as the global economic recovery gains momentum, the time has come to begin tightening monetary policy.
SEOUL – Financial markets around Asia are preparing for a Goldilocks economy in 2018 – not too hot, not too cold, with strong growth and stable prices. The region’s export-oriented emerging economies are benefiting from the recovery in global trade, while its largest players – China, Japan, and India – remain dynamic. Throughout the region, accelerating economic growth, together with positive corporate earnings expectations and persistent capital inflows, are driving up stock prices. And inflation will remain in check, owing largely to the slow rise in wages and import prices.
Yet there remains plenty of cause for concern. For one thing, Asian markets will undoubtedly face capital-flow volatility, driven by the major advanced economies’ monetary policies. For another, large debts could increase financial risk in some Asian economies, damaging growth prospects. The region’s central banks will be integral to managing these risks.
In the wake of the global economic crisis, Asia’s central banks, like their counterparts in the advanced economies, assumed a leading role in supporting domestic growth. But, as the global economic recovery gains momentum, the time has come to begin tightening monetary policy.
The major advanced economies’ central banks are already on that path. The European Central Bank, the Bank of England, and the Bank of Japan are moving to rein in their swelling balance sheets and raise interest rates. But it is the US Federal Reserve that is leading the way.
With low growth in wages and consumer prices keeping inflation subdued, the Fed is likely to continue pursuing gradual interest-rate hikes. But if, as is likely, the tax cuts recently enacted by President Donald Trump and congressional Republicans accelerate economic and price growth enough to raise the risk of economic overheating, the Fed will need to act more assertively.
This broad monetary tightening will have a profound impact on Asia’s emerging economies, which are highly integrated into global markets and thus open to foreign capital flows. In particular, changes in global liquidity conditions are likely to send Asia’s financial and foreign-exchange markets on a roller-coaster ride, fueling pressure to keep up with interest-rate hikes in the advanced economies.
To be sure, some economists still argue that Asia’s central banks should maintain low interest rates, owing to persistently subdued inflation. They worry that, at a time when many households and businesses remain laden with debt, a sharp rate hike would undermine consumption and investment, potentially impeding economic growth.
But the truth is that large debts and overvalued risky assets are the result of sustained monetary expansion. If central banks continue to postpone interest-rate increases for much longer, asset bubbles might develop – not just in the stock and housing markets, but also in, say, virtual currencies – leading to another financial crisis.
The best way to avoid such an outcome is for emerging Asian economies to increase rates gradually and predictably. This does not mean that Asia’s central banks should simply bow to external pressure. Rather, each central bank should pursue monetary-policy normalization at a rate appropriate to safeguarding macroeconomic stability without damaging domestic economic activity.
The good news is that Asia’s central banks seem to recognize this, and are already moving toward tightening, with the Bank of Korea in the lead. On November 30, against a backdrop of rapidly accumulated household debt and distortions in capital allocation, the BOK raised rates by 25 basis points, from a record low of 1.25%.
Monetary authorities in countries like Malaysia, Taiwan, Thailand, and the Philippines are expected to follow suit, timing their interest-rate hikes according to economic conditions. In China, too, monetary tightening will be needed to mop up excess liquidity and reduce leverage. Otherwise, according to Zhou Xiaochuan, the governor of the People’s Bank of China, the country might face a “Minsky moment,” in which excessive optimism and debt-financed investment culminate in financial crisis.
The main potential hitch in this process is political: because ultra-low interest rates amount to an easy form of economic stimulus – much easier than, say, labor, tax, or regulatory reforms – politicians might put pressure on central banks to delay rate hikes. But central banks, leaning on their hard-won independence, must not succumb. Though the active monetary policy used since the global economic crisis has caused some to question central-bank independence, compromising it for the sake of political accountability would, as Barry Eichengreen has put it, be tantamount to “throwing the baby out with the bathwater.”
Standing up to politicians may not be easy for central bankers, not least because, in many countries (including China, Indonesia, Japan, South Korea, and Taiwan), the central bank’s governor is due to be replaced or reappointed in the coming months. The new leaders will need to enter their positions with confidence, and remain steadfast in their decision-making in the face of large-scale uncertainty.
That said, central bankers should not be solely responsible for supporting low and stable inflation and maintaining financial stability. They certainly cannot be expected to drive job creation and output growth in the long term. That is why they must cooperate with policymakers, including fiscal authorities and financial regulators, to ensure the right mix of monetary and fiscal policy, as well as structural reform.
A decade after the global economic crisis began, the world economy is on the path toward normalcy – a path that demands the gradual tightening of monetary policy in Asia and the West alike. It is now up to central banks to meet that demand, without derailing the recovery.
Central Banks Must Work Together – or Suffer Alone
In recent years, the world’s major central banks have pursued unprecedentedly easy monetary policies, characterized by ultra-low and even negative interest rates. These policies are turning out to be a classic bad equilibrium: each central bank stands to gain by keeping interest rates low, but, collectively, low rates constitute a trap from which none can escape.
NEW YORK – Global growth seems to be moving, slowly but surely, along the path to recovery. The International Monetary Fund’s latest World Economic Outlook predicts 3.5% global growth this year, up from 3.2% last year. But there’s a hitch: the easy monetary policies that have largely enabled economies to return to growth are reaching their limits, and now threaten to disrupt the recovery by creating the conditions for another financial crisis.
In recent years, the world’s major central banks have pursued unprecedentedly easy monetary policies, including what a recent Deutsche Bank report calls “multi-century all-time lows in interest rates.” That, together with large-scale quantitative easing, has injected a massive $32 trillion into the global economy over the last nine years. But these unconventional policies are turning out to be a classic game-theoretic bad equilibrium: each central bank stands to gain by keeping interest rates low, but, collectively, their approach constitutes a trap.
In today’s globalized world, a slight reduction in interest rates by an individual central bank can bring some benefits, beginning with weakening the currency and thus boosting exports. But the more countries employ this strategy, the greater the strain on the banking sector. This is already apparent in Europe, where bank equity prices have dropped steadily in recent months.
Moreover, low and especially negative interest rates make holding cash costly, prompting investors to seek riskier investments with higher potential returns. As a result, collateralized loan obligations (CLOs) have more than doubled this year, reaching an overall market value of $460 billion. That looks a lot like the surge in collateralized debt obligations (CDOs) that helped to drive the 2008 financial crisis. While the world has implemented more checks and balances for CLOs than it did for CDOs before the crisis, the trend remains deeply worrying.
Finally, persistently low interest rates can cause people to worry about their retirement funds, spurring them to save more. Far from boosting consumption, as intended, monetary stimulus may create an environment that dampens demand, weakening prospects for economic growth.
Today, no single country can steer the world away from this trap. The United States, which might have taken the lead in the past, has ceded its global leadership position in recent years – a process that has been greatly accelerated during the first year of Donald Trump’s presidency. Moreover, the G20 has lately lost steam in supporting closer coordination of monetary and fiscal policies among the world’s major advanced and emerging economies.
Perhaps a new grouping of the major players – the GMajor? – needs to step up, before it is too late. To gain the needed motivation, monetary policymakers should recall the “traveler’s dilemma,” a game theory parable that highlights the pitfalls of individual rationality.
The parable features a group of travelers, returning home with identical pottery purchased on a remote island. Finding that the pottery has been damaged in transit, they demand compensation from the airline. Because the airline manager – known as the “financial wizard” – has no idea what the price of the pottery is, a creative solution is needed to determine the appropriate amount of compensation.
The manager decides that each traveler should write down the price – any integer from $2 to $100 – without conferring with one another. If all write the same number, that figure will be understood as the price, and thus the amount of compensation each traveler receives. If they write different numbers, the lowest number will be taken as the correct price. Whoever wrote the lowest number would receive an additional $2, as a reward for honesty, while anyone who wrote a higher number would receive $2 less, as a penalty for cheating. So if some write $80 and some $90, they will receive $82 and $78, respectively, in compensation.
At first blush, the travelers are thrilled. The pottery has no actual monetary value, but if they each write $100, all can receive $100 in compensation. One traveler, however, quickly realizes that writing $99 would be a better option, because it would garner that extra $2 reward, and thus a total of $101. That traveler quickly realizes, however, that others must have had the same idea, and so decides to put down $98 instead. But what if the others had the same thought? Better make it $97.
In the end, trapped by this inexorable logic, all travelers end up writing and receiving $2. The outcome may seem a disaster, but it is also the most rational choice – the “Nash equilibrium” of the traveler’s dilemma game. It is clear how the financial wizard came by his moniker.
The moral of the story is simple. The invisible hand of the market does not always lead individually self-interested agents to a collectively desirable outcome. Altruism and regard for others must play a role. If they are missing, the players at least need to coordinate their decisions. Unless central bankers take that message to heart, they will find themselves sweeping up a lot of broken pottery.