Uneasy Money

In my previous post, I pointed out that Ben Bernanke’s incoherent testimony on the US economy and Fed policy last Wednesday was followed, perhaps not coincidentally, by a 2% intraday drop in the S&P 500 and by a 7% drop in the Nikkei average. The drop in the Nikkei was also accompanied by a big drop in long-term bond prices, and by a big jump in the yen against all major currencies (almost 2% against the dollar).

For the past six months or so, ever since it became clear that Shinzo Abe and his Liberal Democratic party would, after two decades of deflation, win the December elections on a platform of monetary expansion and a 2% inflation target, the Nikkei average has risen by over 50% while the yen has depreciated by 25% against the dollar. The Japanese stock-market boom also seems to have been accompanied by tangible evidence of increased output, as real Japanese GDP increased at a 3.5% annual rate in the first quarter.

The aggressive program of monetary expansion combined with an increased inflation target has made Japan the poster child for Market Monetarists, so it is not surprising that the tumble in the Nikkei average and in the Japanese long-term bonds were pointed to as warning signs that the incipient boom in the Japanese economy might turn out to be a flop. Scott Sumner and Lars Christensen, among others, effectively demolished some of the nonsensical claims made about the simultaneous drop in the Japanese stock and bond markets, the main point being that rising interest rates in Japan are a sign not of the failure of monetary policy, but its success. By looking at changes in interest rates as if they occurred in vacuum, without any consideration of the underlying forces accounting for those changes – either increased expected inflation or an increased rate of return on investment – critics of monetary expansion stumble into all sorts of fallacies and absurdities.

Nevertheless, neither Scott nor Lars addresses a basic problem: what exactly was happening on Black Thursday in Japan when stock prices fell by 7% while bond prices also fell? If bond prices fell, it could be either because expectations of inflation rose or because real interest rates rose. But why would either of those be associated with falling stock prices? Increased expected inflation would not tend to reduce the value of assets, because the future nominal value of cash flows would increase along with discount rates corresponding to the expected loss in the purchasing power of yen. Now there might be some second-order losses associated with increased expected inflation, but it is hard to imagine that they could come anywhere close to accounting for a 7% drop in stock prices. On the other hand, if the increase in interest rates reflects an increased real rate of return on investment, one would normally assume that the increased rate of return on investment would correspond to increased real future cash flows, so it is also hard to understand why a steep fall in asset values would coincide with a sharp fall in bond prices.

Moreover, the puzzle is made even more perplexing if one considers that the yen was appreciating sharply against the dollar on Black Thursday, reversing the steady depreciation of the previous six months. Now what does it mean for the yen to be appreciating against the dollar? Well, basically it means that expectations of Japanese inflation relative to US inflation were going down not up, so it is hard to see how the drop in bond prices could be attributed to inflation expectations in any event.

But let’s just suppose that the Japanese, having experienced the positive effects of monetary expansion and an increased inflation target over the past six months, woke up on Black Thursday to news of Bernanke’s incoherent testimony to Congress suggesting that the Fed is looking for an excuse to withdraw from its own half-hearted attempts at monetary expansion. And perhaps — just perhaps — the Japanese were afraid that a reduced rate of monetary expansion in the US would make it more difficult for the Japan to continue its own program of monetary expansion, because a reduced rate of US monetary expansion, with no change in the rate of Japanese monetary expansion, would lead to US pressure on Japan to prevent further depreciation of the yen against the dollar, or even pressure to reverse the yen depreciation of the last six months. Well, if that’s the case, I would guess that the Japanese would view their ability to engage in monetary expansion as being constrained by the willingness of the US to tolerate yen depreciation, a willingness that in turn would depend on the stance of US monetary policy.

In short, from the Japanese perspective, the easier US monetary policy is, the more space is available to the Japanese to loosen their monetary policy. Now if you think that this may be a bit far-fetched, you obviously haven’t been reading the Wall Street Journal editorial page, which periodically runs screeds about how easy US monetary policy is forcing other countries to adopt easy monetary policies.

That’s why Bernanke’s incoherent policy statement last Wednesday may have led to an expectation of a yen appreciation against the dollar, and why it also led to an expectation of reduced future Japanese cash flows. Reduced expectations of US monetary expansion and US economic growth imply a reduced demand for Japanese exports. In addition, the expectation of US pressure on Japan to reverse yen depreciation would imply a further contraction of Japanese domestic demand, further reducing expected cash flows and, consequently, Japanese asset prices. But how does this account for the drop in Japanese bond prices? Simple. To force an increase in the value of the yen against the dollar, the Bank of Japan would have to tighten money by raising Japanese interest rates.

PS Lars Christensen kindly informs me that he has a further discussion of Japanese monetary policy and the Nikkei sell-off here.