Japan’s Monetary Experiment

The BoJ has embarked on a radical new adventure:

BOJ shocks with new base money target, boosts asset buying

TOKYO: The Bank of Japan shocked markets on Thursday with a radical overhaul of its policymaking, adopting a new balance sheet target and pledging to double its government bond holdings in two years as it seeks to end nearly two decades of deflation.

At new Governor Haruhiko Kuroda's first policy-setting meeting, the central bank shifted its monetary policy target to the monetary base from the overnight call rate, which is set at a range of zero to 0.1 percent.

The unexpected scope of the changes Kuroda pushed through drove the yen lower and knocked the 10-year bond yield to its lowest in a decade.

"The BOJ will conduct money-market operations so that the monetary base will increase at an annual pace of about 60 trillion yen to 70 trillion yen (£426.9 billion to £499.7 billion)," the central bank said in a statement announcing the decision.

It also combined two bond-buying schemes, its asset-buying and lending programme and the "rinban" bond-buying market operation, to buy government bonds across the yield curve including those with duration of 40 years.

The BOJ will revert to open-ended asset purchases and buy over 7 trillion yen ($75 billion) of long-term government bonds per month, so that the balance of its bond holdings increase at an annual pace of 50 trillion yen, the central bank said.

The central bank will also increase purchases of exchange-traded funds (ETF) by 1 trillion yen per year and real-estate trust funds (REIT) by 30 billion yen per year.

The decisions were made by a unanimous vote, marking the start of Kuroda's drive toward aggressive monetary easing to achieve the new 2 percent inflation target.

As much as I think monetary policy is a powerful lever for managing an economy, I think this policy change to be unwise. Always bearing in mind of course that I’m not Japanese, have no stake in this problem, and don’t know enough about the Japanese economy to pontificate with any authority on this issue.

Nevertheless, from a monetarist perspective we have the historical experience of the 1980s, when monetary base targeting was last tried. The result was that previously stable relationships between the money supply and GDP became unstable. In other words, changing the instrument itself doesn’t necessarily help.

From a market monetarist perspective, this is also not ideal as the BoJ is still using an intermediate target (inflation) to affect changes to long term interest rates, credit creation and incomes. You’re not making a direct stab at stabilising the path of nominal income growth.

I’m also of the view that Japan’s decades long “stagnation” is more due to demographic factors than lack of dynamism. Japan has the second “oldest” population in the world with a median age of about 44.6 in 2010. The population has begun to shrink and should lose about 25% of the population in the next 70 years or so.

Growth on a per capita basis remains on par with Europe and nearly as good as the US. Given its level of technology, productivity is still growing but is being offset by a declining population base.

As such, there isn’t in fact a growth problem. If you take all those into account, Japan is actually right where it should be. Both deflation and the trade deficit could be attributed to the same factors – when overall demand is falling (cumulatively less consumers over time), you would expect pressure on the price level to be low. You’d also expect to see an older population, with many above retirement age, to begin to dis-save relative to income, which at an aggregate level would manifest itself as a deficit on the current account.

The alternative explanation is that the Yen suffers from safe haven status and is overvalued, in which case, more aggressive monetary easing might be warranted. But the Yen’s strength could also be tied to demographics – “older” populations (with higher incomes and a higher domestic price level) are positively correlated with stronger exchange rates.

So I’m afraid that the BoJ might just be blowing bubbles.