With the US Federal Reserve now adopting what is widely regarded as some variant of quantitative easing (QE), and with the Bank of Japan cutting interest rates amidst economic conditions which BoJ Governor Masaaki Shirakawa describes as "severe", perhaps it is worth taking time out to have a looking at some of the earlier experience of quantitative easing in Japan, in order to ask ourselves why it is that central banks may favour this particular approach this time round, and why it is that with monetary policy at very low levels in a number of countries we are not seeing a simple knee-jerk return to/introduction of some form of Zero Interest Rate Policy (ZIRP). In order to answer such questions we will also need to look at the (none to evident) issue of whether or not it is the case that this week's decisions at the BoJ to all effect and purpose do actually constitute a return to QE.
To anticipate a little bit what will be argued in this rather lengthy post, there is a fundamental difference between the recent move towards QE taken by the Fed (especially after the end of September as explained by James Hamilton in this excellent post), and the policy pursued by the BoJ between 2001 and 2006, and this difference concerns the objectives of the policy. While both initiatives have in common that they are strategies to get that "something extra" out of monetary policy in a very low interest rate environment (near the so-called zero bound), they differ in that the Fed's current objective is to provoke a recovery in economic activity in the US, whereas the BoJ had the objective of provoking a sustained rate of inflation above zero. Obviously the two processes - provoking growth and provoking inflation - are related, but there are also subtle differences in the way the respective banks attempt to achieve these objectives. The Fed is concerned about the liquidity question as part of an ongoing attempt to ease a credit crunch, which it is trying to do by bringing yield spreads (and in particular the so called TED spread) down. No one doubts that once this objective is achieved the Fed will rapidly wind down its balance sheet just as rapidly as it wound it up at the end of September. The BoJ, on the other hand, was concerned to convince market participants that the excess balances would be maintained for a long time interval, beyond the point where the price index simply indicated it might move into positive territory. The BoJ had to convince market participants that they were serious about provoking inflation (that is, what they were really targetting weren't bank reserve balances as such, since they were simply using the levels of these balances as an indirect tool for influencing inflation expectations) while the Fed (at this point at least, of course on a worst case scenario of outright deflation in the US, I am sure Bernanke has a Japan-style "plan b" up his sleeve) currently has no inflation target beyond its general objective of price stability and is not trying to steer inflation expectations upwards. Not yet, anyway. And with that caveat......
The BoJ Cuts Rates, But Not To Zero
So if the Fed isn't exactly applying the BoJ 2001-2006 playbook at the present time, what about the BoJ, is it applying some kind of Bernanke style markII QE, and expanding its balance with the objective of easing the credit crunch? Well, this is a much more plausible interpretation of what is happening, and in some senses the earlier BoJ move (in October) in lowering interest rates from 0.5% to 0.3% could be thought of as some kind of initial step towards the reintroduction of some kind of QE in Japan, while last Friday's cut in the BOJ key policy rate to 0.10 percent (when taken together with the commitment to expand the balance sheet, increase its purchase of JGBs and begin outright purchases of commercial paper) really represents its de-facto initiation , despite the fact that Governor Shirakawa was quick to stress that the bank's decision to cut interest rates and buy more assets did not mark a direct and immediate return to the earlier version of quantitative easing. He was able to say this because the BoJ - despite the evident danger signals - still does not anticipate a return to deflation, and thus is not willing to undertake any commitment to provoke inflation. Of course, they may well be criticised later for not being sufficiently proactive here, just as they were in 1998/1999.
What the BOJ did decide to do was raise the ceiling on the amount of Japanese government bonds it buys each month from 1.2 trillion yen to 1.4 trillion (a 17% increase), as well as committing itself to the purchase a of wider range of bonds, and expanding the range of eligible JGBs to include 30-year bonds, floating rate bonds and inflation-indexed bonds.
The Bank also decided to temporarily buy commercial paper outright, following in the footsteps of the U.S. Federal Reserve, despite the strong reservations which have been expressed by a number of BOJ officials in the past about accepting such assets with credit risk. In fact the Bank of Japan has long accepted commercial paper as collateral in its fund operations (and indeed such purchases were an important ingredient in the earlier QE experiment) but has up to now resisted calls to purchase them directly from issuers. The terms and conditions for such purchases still have to be decided, while Governor Shirakawa is still voicing his doubts, so in its press release the BoJ simply stated that all that it had done at this point was undertake to examine the range of corporate instruments and the degree of risk taking that are appropriate for the BoJ.
Thus the BoJ has obviously taken an important step, and is clearly open to the idea that such purchases could be a major instrument in monetary policy. We will obviously need to see more of the details, and some indication of the size of the CP-programme before we can be clearer about how aggressively the BoJ intends to proceed with the initiative at this point, although evidently, once the door is open the measures can obviously be expanded as the situation evolves.
What we can say with rather more conviction is that BoJ policy at this point seems to be oriented more towards the spread between three-month JGBs and the three-month interbank offered rate, Tibor, which rose to its highest level in a decade(0.922%) on December 16 before falling three straight days to hit 0.905% at the Friday fixing. The difference between what the government and Japan’s banks pay to borrow for three months, the so-called TED spread, was running at 46 basis points in mid-week, and this compares with an average of 16 basis points for 2007.
Fiscal And Monetary Tandem
To some extent fiscal and monetary policy is moving in tandem in Japan at the present time (as it is in the US) and the Japanese government also announced last week that it was going to purchase commercial paper, saying that it would buy as much as 20 trillion yen worth of shares held by banks in order to to boost their capital. The measure formed part of an emergency stimulus package worth 43 trillion yen ($489 billion). Thus nearly half of the package will be for purchasing commercial banks' equity holdings as part of efforts to improve the lenders' liquidity, according to the Nikkei business daily.
Evidently if such measures are approved by the Japanese parliament they will push spending to even higher levels. The Finance Ministry's draft budget suggested a spending increase of 6.6 percent to 88.5 trillion yen ($990.9 billion) for the next fiscal year — the biggest ever figure in an initial proposal. The budget proposal expects general spending to rise to 51.7 trillion yen ($578.9 billion) in the next fiscal year, even though tax revenue is projected to fall 13.9 percent to 46.1 trillion yen ($516.2 billion). As a result, Japan will see its primary budget deficit jump to more than 13 trillion yen ($145.6 billion) from 5 trillion yen ($56 billion) this year. This will mean bond issuances will need to rise to 33.9 trillion yen - up by 31.3 percent over fiscal 2008 - to cover the revenue shortfall. The expansion means saying an effective goodbye to Japan's governments goal of balancing the budget by 2011. But Prime Minister Taro Aso, whose popularity rating is falling more quickly than the Spanish construction industry, has made it clear he sees no role for fiscal discipline at a time like this.
In the current fiscal year (which ends next March) tax revenues are now expected to fall 7.13 trillion yen short of an initial estimate of 53.55 trillion yen due to slump in corporate tax revenues as the economy has slid into a recession. The bulk of the tax revenue shortfall will be covered by the government issuing deficit-covering bonds in the second supplementary budget that totals 4.8 trillion yen. To fund the economic steps through the extra budget, the government will also issue so-called construction bonds, which are used for specified purposes such as public works, worth 390 billion yen while dipping into reserves set aside in a special account for "zaito" fiscal investment and loan programmes (FILP). Thus spending in fiscal 2009 is expected to rise by 9.4% while revenue is expected to fall by 13.9% with evident consequences for the fiscal deficit and the size of the accumulated government debt.
On 12 December Prime Minister Aso introduced a 23 trillion yen "livelihood protection package". As part of that package there was a 2 trillion yen ($22 billion) CP purchasing allowance and the government instructed the Japan Finance Corporation (JFC) to engage in "crisis respone operations" and help struggling companies. The Development Bank of Japan is to serve as cashier to fund the CP purchases. Japan's 124 commercial lenders had 25.6 trillion yen in stockholdings at the end of March.
Around 1 trillion yen of low-interest financing for medium to large enterprises was also included and this expenditure will be counted as part of the Fiscal Investment and Loan Programme (FILP), and as a result the programme will expand for the first time in ten years. The ruling LDP has also established a new body the Team To Realise Financial and Real Estate Countermeasures, and this body seems to be pressing for the BoJ to commence open market purchases of JGBs and stocks and REITs, with the estabishment of an entity to purchase more than 10 trillion yen of stocks.
Why Not All The Way To Zero?
Certainly in the United States, it increasingly seems that Ben Bernanke has decided to adopt QE rather than a more straightfoward lowering of the federal funds rate directly to zero. Part of the thinking which lay behind this move was explained by Bernanke himself, in a paper he prepared with Vincent R. Reinhart (Director, Division of Monetary Affairs, Federal Reserve Board) back in 2004.
Bernanke and Reinhart give two reasons for not going all the way to zero. Firstly:
Observers have pointed out that rates on financial instruments typically priced below the overnight rate, such as liquid deposits, shares in money market mutual funds, and collateralized borrowings in the "repo" market, would be squeezed toward zero as the policy rate fell, prompting investors to seek alternatives. Short-term dislocations might result, for example, if funds flowed in large amounts from money market mutual funds into bank deposits. In that case, some commercial paper issuers who have traditionally relied on money market mutual funds for financing would have to seek out new sources, while banks would need to find productive uses for the deposit inflows and perhaps face changes in regulatory capital requirements. In addition, liquidity in some markets might be affected; for example, the incentive for reserve managers to trade federal funds diminishes as the overnight rate falls, probably thinning brokering in that market.
"A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero instrument rate as evidence that the central bank has "run out of ammunition." That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate."
Thus, in the first place distortions occur in the normal functioning of the money markets, while in the second a mis-perception arises (on Bernanke's view) among the public that policy is ineffective and that the central bank can then do nothing. Both these lines of reasoning may help explain why the preferred line of attack at this point is to take rates to a very low level, just above zero, but not all the way to zero.
Quantitative Easing In Japan
Returning for a bit to the Japanese experience of QE in the early years of this century, we find that the Bank of Japan embarked (back in March 2001) on what was then an unprecedented monetary policy experiment. This experiment, which is commonly referred to as "quantitative easing," was an attempt to stimulate a Japanese economy which had become stagnant under the dead weight on continuing ongoing deflation expectations and a monetary policy which seemed to have gotten stuck at what had become known as the "zero bound". The BoJ had come under considerable criticism from a number of academic economists (most notably Ben Bernanke and Paul Krugman, see bibliography below) for failing to respond aggressively enough to the deflation problem in the 1990s.
QE was introduced as a response to what was seen as the failure of earlier monetary policy. As a response to the growing deflation problem following the onset of a sharp recession Japan lowered its overnight call rate from around 0.43% to 0.25% in September 1998. The rate was further lowered to near 0% in March 1999. In April 1999, the BOJ made an initial promise (subsequently seen as inadequate) to maintain a zero interest rate “until deflationary concerns are dispelled” - thus began the so-called zero interest rate policy (ZIRP). Following the application of this policy the Japanese economy appeared to be recovering, although not the price level, since it grew at a 3.3% year on year pace between Q3 1999 and Q3 2000. As a result the BoJ abandoned the ZIRP policy in August 2000, and it was this abandonment which has been the object of so much criticism - especially, and most notably, from Paul Krugman.
The economy, however, rapidly fell back into another serious recession following the global decline in the demand for high-tech goods subsequent to the internet bust. Actually my feeling here is that many of the critics are confusing two (logically, if not always practically) separate issues here, the export dependence of an elderly Japanese economy with insipid domestic demand growth, and the problem of the internal price level, or deflation. The two are obviously inter-related, but not so simply as to say that the Japanese economy fell back into recession due to the 2000 BoJ tightening of monetary policy. Undoubtedly the deflation problem worsened as a result of this policy, but the recession came because Japan was unfortunate enough to apply this policy just as the global economy went south bigtime, and again we can see the same sort of process at work in 2007, since the move of Japan's economy back towards recession is connected with export dependence (which could be to do with the high median age of its population) and not a by-product of the decision to end QE in 2006.
Be all this as it may, as a reaction to the renewed recession the BOJ announced the introduction of the quantitative easing policy in March 2001.
As I say above a key component of QE is the way the central bank handles expectations, and the BOJ initially committed to maintain the policy until the core consumer price index registered "stably" a 0% or a positive increase year on year. This commitment was further modified in October 2003 when the BOJ committed itself to continue providing ample liquidity "until both actual and expected inflation turned positive".
The core of QE was the maintainence of an ample liquidity supply by using the current account balances (CABs) at the BOJ as the operating policy target, with the commitment to maintain ample liquidity provision until the rate of change in the core CPI becomes positive on a sustained basis. Thus the focus of policy becomes not the interest rate itself, but the amount of liquidity as reflected in the current balances. In fact during the ZIRP period, the overnight call rate never actually reached zero, but declined to at most 0.01%, while during the period of QE, the rate further declined to 0.001%.
The BOJ also announced that it was ready to increase the amount of purchases of long-term government bonds in order to meet the target on the CABs. The target on the CABs was raised several times, reaching ¥ 30-35 trillion in January 2004, compared to the baseline required reserves which were running at approximately ¥ 6 trillion. In order to meet such targets the BOJ conducted various purchasing operations including the purchase of bills and commercial paper (CPs) in addition to treasury bills (TBs) and government bonds. After 2003, the BOJ also started buying asset-backed commercial paper (ABCPs) and asset-backed securities (ABSs).
Initially the CAB target was set at ¥ 5 trillion (in March 2001) at a time when the level of CABs was around ¥ 4 trillion, thus the initial diffeence was not that great. By May 2004 the CABs had grown eightfold, with an average annual growth rate of 92%. The principle vehicle of liquidity intervention was the purchase of JGBs and during the same period the BoJ purchased ¥ 37.8 trillion in Japan government bonds. The amount of monthly purchases of JGBs has been set and pre-announced by the BOJ. This amount was equivalent to 0.4 trillion yen per month in March 2001 and was gradually increased to 1.2 trillion yen by May 2004. As a result of these policies Japan's monetary base grew by 67% over the same period.
The three building blocks of Japanese QE were thus ensuring ample liquidity provision, commitment to continue such liquidity provision, and the use of various types of market operations, especially purchasing of long-term government bonds, and in many ways these correspond to the three balance sheet expansion mechanisms identified by Bernanke and Reinhart (2004) whereby a central bank can operate an expansionary monetary policy even at very low interest rates.
However, the two approaches are not identical. The BOJ policy of increasing the CAB target may have had the effect of making the liquidity-providing commitment more credible, and the BOJ’s long-term government bond purchasing operations certainly represented the major tool to meet the target on the CABs. The possibility remains, however, that changes in the composition of the BOJ’s balance sheet caused by its market operations have had some effects on the term structure of interest rates. While there exist differences between the policies these authors propose and those adopted by the BOJ, the basic ideas are the same. Even at a zero short-term interest rate, it is possible to pursue further monetary easing that affects expected future short-term interest rates and thus current long-term interest rates through a commitment to appropriate future monetary policy paths.
The policy was lifted five years later, in March 2006. At the launch of the program, many were skeptical that it would have any impact on the real economy, as overnight interest rates were already close to zero, and thus flooding Japanese commercial banks with excess reserves might only amount to swapoing two assets both of which had close to zero yields. Others had been highly critical of the Bank of Japan in the years prior to the introduction of QE (among others Ben Bernanke himself, see here), in particular for their strong reluctance to engage in open ended "unsterilised" interventions. With the introduction of quantitative easing all of that changed to some considerable extent.
Whether the ZIRP and/or RZIRP have affected expected future short-term interest rates, however, is a more subtle question than it initially appears to be. Even without any commitment by the central bank, the market normally forms expectations about future monetary policy stances, ie the path of short-term interest rates.
The Latest Fed Initiative
The Federal Reserve Open-Market Committee decided this week that it was going to use “all available tools” in an attempt to generate a resumption of GDP growth in the United States. This, and the maintenance of price stability, would seem to be the Fed's principal objectives at the present time, and the effective demotion of the benchmark interest rate as a focus of policy attention (the target for overnight loans between banks will henceforth and until conditions improve be maintained in a range between zero to 0.25 percent) is merely a commitment to maintaining a low interest rate environment while the other tools, the balance sheet enhancing ones, do the actual heavy lifting. Since this rate objective is now not going to change in the foreseeable future (the Fed's commitment is for "as long as it takes"), the focus of attention will turn to the liquidity providing measures which the Fed will adopt and to the TED spread as an indicator of the degree of severity of the credit crunch.
As a consequence the Federal Reserve is now exploring a wide range of possibilities, including open market purchases of lower-rated securities, with backing from the Treasury. The Fed thus looks set to expand its current $600 billion initiative to buy debt issued or backed by the government-chartered mortgage-finance companies - it is alreadt trying to lower mortgage rates via the purchase of up to $100 billion of Fannie Mae and Freddie Mac debt as well as $500 billion of mortgage-backed securities they have guaranteed. It is also “evaluating” purchases of longer-term Treasury securities. It may well also enhance other existing programs which include the purchase of commercial paper from companies and financial firms and a offering a backstop for money-market mutual funds.
Thus composition and size of its balance sheet will now be the Fed’s principal policy focus, and, in a key difference with Japan’s earlier quantitative easing experience, the Fed is targeting specific assets for purchase to lower credit spreads rather than expanding the amount of cash in the banking system per se. In fact the Fed will still work to maintain large quantities of liquidity in the bank reserve balances, but whereas the BoJ principally increased the balances through the purchase of JGBs the Fed is placing much more emphasis on the direct purchase of agency securities, on the acquisition of mortgage-backed securities and on lending money directly to the private sector.
“The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level,” the FOMC said.
The Fed “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Federal Open Market Committee said today in a statement in Washington. “Weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”
These moves have already increased the Fed’s balance sheet substantially, and it has risen to a current $2.26 trillion from $868 billion in July 2007. And in addition there is the $700 billion Troubled Asset Relief Program, which the U.S. Treasury has been using since October to channel about $335 billion of capital injections into banks and other financial institutions.
The federal funds target rate has been steadily weakening as a monetary policy tool simply because the flood of funds the Fed has been sending to the markets since late September has meant that the average daily rate (or effective rate) has trade below the actual policy goal rate on every day since Oct. 10. The gap between the target and the effective rate, or average daily market rate, has averaged about a half point since September 12. The gap averaged just above zero from the start of this year up to September 12. This state of affairs is thus not that dis-similar from the Japanese situation in 1998/99, since at that point the actual Japanese overnight market rate was systematically trading below its overnight target and a reluctant BoJ was eventually forced to cut its target rate in two small steps.
So is this quantitative easing? Well the Fed statement said simply that it would be using its balance sheet to support credit markets and the economy, however a senior Fed explained to the somewhat bemused journalists that the bank's approach is seen as being distinct from quantitative easing as practised by the Japanese. The official pointed out that Fed's balance sheet has two sides: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan's quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed's focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. This securities-lending approach is intended to directly affects credit spreads, which is where the Fed perceives the problem to be today.
The Fed official stressed in his explanation that the Fed does not expect deflation, but expects inflation to fall.
Quantitative Easing Or Not Quantitative Easing?
So do we or don't we have quantitative easing in Japan? Well my opinion is that the BoJ has effectively turned to some kind of quantitative easing regime, despite protests to the contrary from Governor Shirakawa at the BoJ post meeting press briefing. But this version of QE is different from the previous one, since the BoJ is not targeting inflation expectations at this point. Governor Shirakawa has argued strongly for keeping short-term money market interest rates slightly positive to improve the functioning of the money market, so it is unlikely the BoJ will move to further reduce the overnight target rate. What I do think we will see, however, is more moves to expand the BoJ's balance sheet, focussing initially the asset side and on the three-month Tibor rate spread with three-month JGBs - purchasing ever increasing quantities of government debt, followed by a subtle shift over to emphasising the liabilities side of the balance sheet, and the size of current balances as deflation locks in and the bank once more attempts to "steer" expectations about the price level.
To try to help us understand where we are, and where we aren't here, below I am reproducing a selection of Sirakawa's comments in the press conference which followed the rate setting meeting.
Shirakawa's Comments After The Announcement
"In broad terms, Japanese interest rates are already close to zero. The last time the BOJ adopted quantitative easing, it aggressively supplied cash to markets to push down rates to zero. In that sense, we haven't adopted quantitative easing or a zero rate policy ...
"It was a decision reached after a comprehensive assessment on how to stimulate the economy and also pay heed to market functions."
"Of course, we can't say we will never opt for a certain monetary policy step in the future. This time we cut the call rate target but left the interest we pay to excess reserves parked at the BOJ at 0.1 percent, after much debate about how to maintain money market functions ...
"We cut rates to 0.1 percent and decided to buy various assets, but these measures are not aimed at expanding the BOJ's balance sheet. We will of course aim to stabilise financial markets and support corporate financing. We are taking measures for these purposes, not to expand our balance sheet."
(Asked about the effect of the BOJ's past experience of pledging to keep monetary conditions easy until consumer inflation emerged, or so-called 'policy duration effect')
"Pledging to maintain low interest rates even when the economy was recovering had a certain effect in pushing down long-term interest rates ... When the economy is in bad shape, no one believes the central bank will raise rates so the impact of the commitment is not big."
"We've raised JGB buying by 200 billion yen in the past. So I think it was a natural increment........We'll start buying long bonds and we'll start buying based on maturity ... Long bonds will remain on our balance sheet for a long time. But we judged that our holding of JGBs will remain below the amount of notes in circulation even after the increase.......I'm not planning to increase the amount of JGB buying further for the time being......Regarding the question of whether we are aiming at bringing down long-term interest rates, the increase in the purchase of long-term bonds is not aimed at that.
"This is about money market operations, not about lowering long-term interest rates......It is aimed at avoiding a distortion of money markets that could occur by relying too much on short-term market operations in providing long-term funds......The increase could affect the demand-supply balance of a certain sector of JGBs as a result. But we are not aiming to reducing risk premium (on long-term bonds)."
"The last time Japan adopted quantitative easing, it was a policy aimed at stimulating the economy through massive liquidity supply by targeting the amount of current account reserves at the BOJ. In this sense, both the United States and Japan have not adopted quantitative easing.
"Of course, we continue to provide liquidity actively to maintain financial market stability and smooth corporate financing. The current account balance could increase as a result of measures to stabilise the financial market and banking system, but that has a somewhat different meaning than last time ...
"Given our experience in the past, we can say that increasing the amount of money was effective in stabilising the financial system. As for its impact on the economy and prices, I'm not saying it didn't have an effect at all. But it was hard to find a clear effect.......It's hard to say anything about the future because members of the policy board could change by then ... Still, no one on the BOJ board seems to think that boosting base money would stimulate the economy."
"Every board member agreed that economic conditions are very severe. We want to stimulate the economy through interest rates but given that rates were already at 0.30 percent so there was limited room for cuts. ......And we wanted to keep the functioning of money markets. We didn't want it to weaken because of our policy.....By cutting interest rates to 0.10 percent, some of the function of money markets may be hampered. But by maintaining positive interest rates, there will remain incentives for trade and the bedrock for financial activity."
Well, there certainly do seem to be a lot of subtleties and nuanceshere, and a lot market observers may well have real difficulties in understanding what he is trying to say, although I do hope that after reading this post, many of my readers may not now be labouring under that difficulty (it certainly took me some time to get through to what was actually going on). In this sense Shirakawa might do well to reflect on this key point in Bernanke and Reinhardt:
"Note that the expectational and fiscal channels of quantitative easing, though not the portfolio substitution channel, require the central bank to make a credible commitment to not reverse its open-market operations, at least until certain conditions are met. Thus, this approach also poses communication challenges for monetary policy makers."
The Fed does seem in this sense to have been somewhat clearer:
"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. "
Did Quantitative Easing As Tool For Monetary Policy Caught In A Liquidity Trap Actually Work In Japan?
Well, this is the three trillion yen question isn't it. Certainly there is no consensus that this policy, rather than the sudden sharp rise in global commodity prices, was what dragged Japanese headline CPI numbers kicking and screaming out of years of deflation, nor is it clear that the termination of this policy, rather than the global trade slump which has followed the credit crunch, is what is sucking the Japanese CPI back below zero. There is little strong evidence on either side about the precise impact of QE on the price level, and certainly any effect there may be is small. Perhaps the best that can be said is that this policy helped avoid a worse outcome, with Japanese prices sinking ever deeper into deflation.
But it does now seem that back we jolly well go, since Japanese core annual inflation slowed in October for a second straight month, raising concerns that the sharp negative energy price shock heightens the risk of a return to deflation as we enter 2009. The core consumer index - which excludes volatile prices of fresh fruit, vegetables and seafood but includes the cost of oil products that are falling rapidly in price - rose 1.9 percent in October from a year earlier, slipping back from the 2.3 percent increase in September. Annual inflation excluding oil products dipped to 1.2 percent while Tokyo figures for November point to further falls in inflation.
If we look at what is known as the "core-core" index (which strips out both energy and fresh food) then we can see that it is far from clear that Japan ever really escaped from the deflation trap, since this reading has been completely flatlining around (and normally slighly below) zero over the last twelve months, and with a very large capacity overhang now developing, this index will almost certainly get back into negative territory very, very soon.
Appendix: Why Japan And The United States Are Different
Finally, should we anticipate a Japanese "outcome" in the United States. I think not. The US economy may well have a brush with deflation in 2009, and monetary policy may not be as effective as Bernanke hopes in avoiding this, but equally the US economy is unlikely to get stuck in deflation in the same way that Japan has (which isn't the same thing as saying we may not see a protracted slowdown in headline US GDP growth) since Japan's ongoing deflation issue is structural, and associated with the country's underlying demographic dynamics. As an illustration of this, I am reproducing here in the form of an appendix some excerpts from one of Paul Krugman's more widely read analytical papers on the Japan problem - It's Baaack! Japan's Slump And The Return Of The Liquidity Trap. Obviously this extract doesn't "establish" anything, but it does provide an illustration of one possible way of looking at the Japan question, and does suggest (since US demographics are very, very different) one good reason for not anticipating a Japan outcome in the US.
One way of stating the liquidity trap problem is to say that it occurs when the equilibrium real interest rate, the rate at which savings and investment would be equal at potential output, is negative. An immediate question is therefore how this can happen in an economy which is not the simple endowment economy described above, but one in which productive investment can take place - and in which the marginal product of capital, while it can be low, can hardly be negative. An answer that may be extremely important in practice is the existence of an equity premium. If the equity premium is as high as the historic U.S. average, the economy could find itself in a liquidity trap even if the rate of return on physical capital is as high as 5 or 6 percent. A further answer is that the rate of return on investment depends not only on the ratio of capital's marginal product to its price, but also on the expected rate of change of that price. An economy in which Tobin's q is expected to decline could offer investors a negative real rate of return despite having a positive marginal product of capital. This point is actually easiest to make if we consider an economy, not with capital, but with land (which can serve as a sort of metaphor for durable capital) - and also if we temporarily depart from the basic setup to consider an overlapping-generations setup, in which each generation works only in its first period of life but consumes only in its second. Let A be the stock of land, and Lt be the labor force in period t - that is, the number of individuals born in that period. Given the special assumption that the young do not consume during their working years, but use all their income to buy land from the old, we have a very simple determination of qt, the price of land in terms of output: it must simply be true that
qt.At = wt.Lt
where wt is the marginal product of labor. So in this special setup q itself is not a forward-looking variable; it depends only on the size of the current labor force. However, the expected rate of return on purchases of land is forward-looking. Let Rt be the marginal product of land, and rt the rate of return for the current younger generation. Then we have that:
1 + rt = Rt+1 + qt+1 /qt
Now suppose that demographers project that the next generation will be smaller than the current one, so that the labor force and hence (given elastic demand for labor) the real price of land will decline. Then even though land has a positive marginal product, the expected return from investing in it can in principle be negative. This is a highly stylized example, which begs many questions. However, it at least establishes the principle that a liquidity trap can occur despite the existence of productive investment projects.
In fact, this exercise suggests that the real puzzle is not why Japan is now in a liquidity trap, but why this trap did not materialize sooner. How was Japan able to invest so much, at relatively high real interest rates, before the 1990s? The most obvious answer is some version of the accelerator: investment demand was high because of Japan's sustained high growth rate, and therefore ultimately because of that high rate of potential output growth. In that case the slump in investment demand in the 1990s may be explained in part by a slowdown in the underlying sources of Japanese potential growth, and especially in prospective potential growth.
As noted above, there is considerable uncertainty about the actual rate of Japanese potential growth in the 1990s. Nonetheless, it is likely that there has been a slowdown in the rate of increase in total factor productivity, even cyclically adjusted. What is certain, however, is that Japan's long-run growth, even at full employment, must slow because of demographics. Through the 1980s Japanese employment expanded at x.x percent annually. However, the working-age population has now peaked: it will decline at x.x percent annually over the next xx years (OECD 1997), and - if demographers' projections about fertility are correct - at a remarkable x.x percent for the xx years thereafter. As suggested by the discussion of investment and q in the first half of this paper, such prospective demographic decline should, other things equal, depress expectations of future q and hence also depress current investment.
Of course, the looming shortage of working-age Japanese has been visible for a long time; indeed, the budgetary consequences of an aging population have been a preoccupation of the Ministry of Finance, and an important factor inhibiting expansionary fiscal policy. Why, then, didn't this prospect start to affect long-term investment projects in the 1980s? One answer is that businesses may have believed that total factor productivity would grow rapidly enough to make up for a declining work force. However, the "bubble economy" of the late 1980s may also have masked the underlying decline in investment opportunities, and hence delayed the day of reckoning.
Excerpted from Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap
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