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Economic News & Analysis—April 4, 2013

A new dawn for the Bank of Japan?

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

In a widely anticipated move, the BOJ announced it would double the size of its asset purchases in an attempt to hit a 2% inflation target over the next two years. By multiplying the monetary base by two in an attempt to hit a 2% inflation target over the span of two years, the BOJ just might leave you wondering if it is doing too much or too little.

The yen weakened relative to the dollar after the announcement from BOJ Governor Haruhiko Kuroda that the BOJ would aim to double its monetary base (currency in circulation and bank reserves) to 270 trillion yen by 2014. The BOJ will likely purchase longer-date Japanese government bonds, real estate investment trusts (REITs), and exchange-traded funds (ETFs) to hit its target in an aggressive way. This is not the first time the BOJ has purchased risky assets such as REITs and ETFs, but it is a massive expansion of its purchase plans.

The BOJ has labeled its policy “Quantitative and Qualitative Monetary Easing.” This is quite similar to the Federal Reserve’s playbook, where the focus is not just on the quantity of assets the central bank purchases but also the quality of assets purchased. Instead of just purchasing government bonds, other assets are also purchased. There is also a verbal dimension to monetary policy, call it “verbal easing,” in terms of communications coming from the central bank. By signaling what the central bank wants to do and when it might do it, the central bank is trying to get more bang for its buck (or yen, in this case). For monetary policy, and even fiscal policy, it’s not what policymakers do, it’s what people think the policymakers may do in the future that matters most. The qualitative statements are an attempt to shape those expectations.

Some words are merely words if they are not expected to be followed up with action. It was important for BOJ Governor Kuroda to announce a plan that was at least in line with the hype around his appointment. I would have preferred a larger asset purchase plan to exceed expectations, but at least he come across as timid.

I am still doubtful as to whether the BOJ will be successful in meeting its inflation target. There are linkages between the monetary base to the money supply and then the money supply to inflation. Some people call this the “transmission mechanism of monetary policy,” but I think the word “mechanism” gives the false sense of precision and predictability, as though it’s some sort of mechanical process by which central bank activity affects the real economy or inflation. Those linkages can loosen, tighten, strain, and break at times.

When I looked at the relationship between the monetary base and the money supply (measured by a monetary aggregate called M2) in Japan and the U.S., that money multiplier (as it is called in economics) is hardly consistent (see chart below). That’s why monetary policy (changing the monetary base) sometimes doesn’t show up in the money supply (changing M2). In order to move from the monetary base to the money supply, you need banks to lend out the reserves the central bank has created. Whether banks do that or not depends on regulatory pressures, whether potential borrowers want to borrow, whether potential borrowers have the capacity to pay back loans, and many other factors.

Source: Factset and author’s calculations.

The relationship between changes in the money supply and inflation is also an imperfect and inconsistent one. Some people talk about the “velocity of money,” a measure of how many times the money supply (not the monetary base) turns over in the economy. In the U.S. and Japan, that measure has collapsed. When it returns to more normal levels, it can show up as either an increase in real economic activity (real gross domestic product) or in higher prices (inflation). As Japan has shown, that process can take a few decades. With an aging population that is repatriating savings from around the world to spend in retirement—which naturally should increase the value of the yen—and after getting accustomed to deflation or no inflation, it could be politically costly to shift to higher inflation. In order to keep the debt servicing cost of the Japanese government’s debt affordable, interest rates will likely need to stay repressed in Japan even as inflation begins to pick up. Elderly savers might not go for that.  

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