Uneasy Money

Archive Page 39

Fear Is Contagious

Ever the optimist, I was hoping that yesterday’s immediate, sharply negative, reaction to the FOMC statement and Ben Bernanke’s press conference was only a mild correction, not the sign of a major revision in expectations. Today’s accelerating slide in stock prices, coupled with continuing ~~rises~~ declines in bond prices, across the entire yield curve, shows that the FOMC, whose obsession with inflation in 2008 drove the world economy into a Little Depression, may now be on the verge of precipitating yet another downturn even before any real recovery has taken place.

If 2008-09 was a replay of 1929-30, then we might be headed back to a reprise of 1937, when a combination of fiscal austerity and monetary tightening, fed by exaggerated, if not irrational fears of inflation, notwithstanding the absence of a full recovery from the 1929-33 downturn, caused a second downturn, nearly as sharp as that of 1929-30.

Nothing is inevitable. History does not have to repeat itself. But if we want to avoid a repeat of 1937, we must avoid repeating the same stupid mistakes made in 1937. Don’t withdraw – or talk about withdrawing — a stimulus that isn’t even generating the measly 2% inflation that the FOMC says its targeting, even while the unemployment rate is still 7.6%. And as Paul Krugman pointed out in his blog today, the labor force participation rate has barely increased since the downturn bottomed out in 2009. I reproduce his chart below.

Bernanke claims to be maintaining an accommodative monetary policy and is simply talking about withdrawing (tapering off), as conditions warrant, the additional stimulus associated with the Fed’s asset purchases. That reminds me of the stance of the FOMC in 2008 when the Fed, having reduced interest rates to 2% in March, kept threatening to raise interest rates during the spring and summer to counter rising commodity prices, even as the economy was undergoing, even before the onset of the financial crisis, one of the fastest contractions since World War II. Yesterday’s announcement, making no commitment to ensure that the Fed’s own inflation target would be met, has obviously been understood by the markets to signal the willingness of the FOMC to tolerate even lower rates of inflation than we have now.

In my post yesterday, I observed that the steep rise in nominal and real interest rates (at least as approximated by the yield on TIPS) was accompanied by only a very modest decline in inflation expectations (as approximated by the TIPS spread). Well, today, nominal and real interest rates (as reflected in TIPS) rose again, but with the breakeven 10-year TIPS spread falling by 9 basis points, to 1.95%. Meanwhile, the dollar continued to appreciate against the euro, supporting the notion that the markets are reacting to a perceived policy change, a change in exactly the wrong direction. Oh, and by the way, the price of gold continued to plummet, reaching $1280 an ounce, the lowest in almost three years, nearly a third less than its 2011 peak.

But for a contrary view, have a look at theeditorial (“Monetary Withdrawal Symptom”) in Friday’s Wall Street Journal, as well as an op-ed piece by an asset fund manager, Romain Hatchuel, (“Central Banks and the Borrowing Addiction”). Both characterize central banks as drug pushers who have induced hundreds of millions, if not billions, of people around the world to become debt addicts. Hatchuel sees some deep significance in the fact that total indebtedness has, since 1980, increased as fast as GDP, while from 1950 to 1980 total indebtedness increased at a much slower rate.

Um, if more people are borrowing, more people are lending, so the mere fact that total indebtedness has increased faster in the last 30 years than it did in the previous 30 years says nothing about debt addiction. It simply says that more people have been gaining access to credit markets in recent years than had access to credit markets in the 1950s, 1960s and 1970s. If we are so addicted to debt, how come real interest rates are so low? If a growing epidemic of debt addiction started in 1980, shouldn’t real interest rates have been rising steadily since then? Guess what? Real interest rates have been falling steadily since 1982. The Wall Street Journal strikes (out) again.

Bernanke Gives the Markets a Scare

Published June 19, 2013 Ben Bernanke , expectations , Federal Reserve , monetary policy 6 Comments
Tags: FOMC, gold

Ben Bernanke held a press conference today at the conclusion of the FOMC meeting held yesterday and today. The stock market had risen by almost 2 percent on Monday and Tuesday, apparently in hopes that Bernanke would have something encouraging to say about Fed policy. They were obviously disappointed. The accompanying chart shows how the S&P 500 has fluctuated since last Thursday, the sharp drop today coincided with Bernanke’s press conference.

S&P500_6-13_6-19

What was so disturbing to the markets? Well, Bernanke’s press conference triggered some sharp movements in the bond markets. The yield on the 10-year Treasury jumped by 13 basis points to 2.33%. I don’t have a chart of the intra-day fluctuation, but I am pretty sure almost all of the movement occurred after the press conference started. Meanwhile the yield on the 10-year TIPS jumped 15 basis points, from 0.14% to 0.29%, implying a 2-basis-point drop in the breakeven TIPS spread, to 2.04%. A two-basis-point change in inflation expectations is not very remarkable. So it seems that what drove the increase in yield was the increase in the real rate. But one has to be careful in identifying the TIPS spread with the real rate of interest, especially when one sees sudden changes in the market, changes that could reflect factors other than the real rate of interest, such as illiquidity in the TIPS market or increasing uncertainty about future inflation, even though expected inflation is not changing much.

Let’s look at two other markets that moved sharply after Bernanke started talking this afternoon. The chart below shows the movement of dollar/euro exchange rate since Monday. The dollar weakened slightly on Monday and Tuesday and Wednesday morning, but as soon as Bernanke got started the dollar shot up against the euro.

That should not necessarily be construed as a vote of confidence in Bernanke, even though it apparently pleased Bernanke et al. to think that the sharp run-up in the value of the dollar in August 2008 was a sign of confidence that Fed policy to keep inflation expectations anchored was working. It is hard to interpret today’s sharp increase in the value of the dollar as anything but an expectation of future tightening of monetary policy by the Fed. But then why did inflation expectations fall by only 2 basis points?

Another market that is supposed to be sensitive to inflation expectations is gold, though in my view the demand for gold is too irrational to provide any usable information about expectations. But I will suspend my disbelief in the rationality of gold traders for the time being to note that the price of gold has just fallen to a new low for the year, dropping below $1340 an ounce or almost 3% since yesterday. A fall in the value of gold is consistent with an increase in real interest rates or with a decline in inflation expectations, so take your pick.

Some people have suggested that declining inflation expectations and rising real interest rates are manifestations of a positive supply shock, also reflected in declining commodity prices. A positive supply shock would have provided the Fed with an opportunity to relax monetary policy further without risk of raising inflation or inflation expectations from current levels, which already are well below the Fed’s announced 2% target. If continued Fed easing was what the markets had been anticipating earlier in the week, reflected in a gently falling dollar exchange rate, even with inflation expectations stable or falling, then Bernanke’s announcement today constituted a tightening of policy relative to expectations. The tightening drove up the dollar and caused a further, albeit small, decline in inflation expectations. (But I should note that this interpretation depends on what may be an oversimplified identification of the TIPS spread with inflation expectations.)

At any rate, I don’t think that we have a clear understanding of what is driving markets at this point. Markets still seem to be in confusion. Today’s movements in the markets were sudden and sharp, but they were also fairly modest. A one or two percent movement in markets is hardly a major event. Nevertheless, by displaying an unseemly haste to withdraw the very modest monetary stimulus that the Fed has begrudgingly provided, Bernanke may have given the markets a bit of scare, reminding them how indifferent central bankers have been to the ongoing disaster of the Little Depression. The markets did not panic, but we may be flying into turbulence. Keep your seat belts fastened.

What’s a Central Banker To Do?

Published June 17, 2013 Ben Bernanke , expectations , Federal Reserve , inflation , QE 11 Comments
Tags: FOMC, George Melloan, Wall Street Journal

The FOMC is meeting tomorrow and Wednesday, and it seems as if everyone is weighing in with advice for Ben Bernanke and company. But you can always count on the Wall Street Journal editorial page to dish up something especially fatuous when the topic turns to monetary policy and the Fed. This time the Journal turns to George Melloan, a former editor and columnist at the Journal, to explain why the market has recently turned “skittish” in anticipation that the Fed may be about to taper off from its latest venture into monetary easing.

Some of us have been arguing that recent Fed signals that it will taper off from quantitative easing have scared the markets, which are now anticipating rising real interest rates and declining inflation. Inflation expectations have been declining since March, but, until the latter part of May, that was probably a positive development, reflecting expectations of increased real output under the steady, if less than adequate, policy announced last fall. But the expectation that quantitative easing may soon be tapered off seems to have caused a further decline in inflation expectations and a further increase in real interest rates.

But Melloan sees it differently

We are in an age where the eight male and four female members of the FOMC are responsible for whether securities markets float or sink. Traders around the world who in better times considered a range of variables now focus on a single one, Federal Reserve policy. . . .

In the bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other to maximize yield. But in the new world of government rigging, they often head in the same direction. That’s not good for investors.

Oh dear, where to begin? Who cares how many males and females are on the FOMC? Was the all-male Federal Reserve Board that determined monetary during the Great Depression more to Mr. Melloan’s liking? I discovered about three years ago that since early in 2008 there has been a clear correlation between inflation expectations and stock prices. (See my paper “The Fisher Effect Under Deflationary Expectations.“) That correlation was not created, as Melloan and his colleagues at the Journal seem to think, by the Fed’s various half-hearted attempts at quantitative-easing; it is caused by a dangerous conjuncture between low real rates of interest and low or negative rates of expected inflation. Real rates of interest are largely, but not exclusively, determined by entrepreneurial expectations of future economic conditions, and inflation expectations are largely, but not exclusively, determined by the Fed policy.

So the cure for a recession will generally require inflation expectations to increase relative to real interest rates. Either real rates must fall or inflation expectations (again largely under the control of the Fed) must rise. Thus, an increase in inflation expectations, when real interest rates are too high, can cause stock prices to rise without causing bond prices to fall. It is certainly true that it is not good for investors when the economy happens to be in a situation such that an increase in expected inflation raises stock prices. But that’s no reason not to reduce real interest rates. Using monetary policy to raise real interest rates, as Mr. Melloan would like the Fed to do, in a recession is a prescription for perpetuating joblessness.

Melloan accuses the Fed of abandoning free markets and rigging interest rates. But he can’t have it both ways. The Fed did not suddenly lose the power to rig markets last month when interest rates on long-term bonds rose sharply. Bernanke only hinted at the possibility of a tapering off from quantitative easing. The Fed’s control over the market is supported by nothing but the expectations of millions of market participants. If the expectations of traders are inconsistent with the Fed’s policy, the Fed has no power to prevent market prices from adjusting to the expectations of traders.

Melloan closes with the further accusation that Bernanke et al. hold “the grandiose belief . . . that the Fed is capable of superhuman feats, like running the global economy.” That’s nonsense. The Fed is not running the global economy. In its own muddled fashion, the Fed is trying to create market expectations about the future value of the dollar that will support an economic expansion. Unfortunately, the Fed seems not to have figured out that a rapid recovery is highly unlikely to occur unless something is done to sharply raise the near term expected rate of inflation relative to the real rate of interest.

Markets in Confusion

Published June 12, 2013 expectations , monetary policy , QE 10 Comments
Tags: Sumner critique

I have been writing a lot lately about movements in the stock market and in interest rates, trying to interpret those movements within the framework I laid out in my paper “The Fisher Effect Under Deflationary Expectations.” Last week I pointed out that, over the past three months, the close correlation, manifested from early 2008 to early 2013, between inflation expectations and the S&P 500 seems to have disappeared, inflation expectations declining at the same time that real interest rates, as approximated by the yield on the 10-year TIPS, and the stock market were rising.

However, for the past two days, the correlation seems to have made a strong comeback. The TIPS spread declined by 8 basis points, and the S&P 500 fell by 2%, over the past two days. (As I write this on Wednesday evening, the Nikkei average is down 5% in early trading on Thursday in Japan.) Meanwhile, the recent upward trajectory of the yield on TIPS has become even steeper, climbing 11 basis points in two days.

Now there are two possible interpretations of an increase in real interest rates. One is that expected real growth in earnings (net future corporate cash flows) is increasing. But that explanation for rising real interest rates is hard to reconcile with a sharp decline in stock prices. The other possible interpretation for a rise in real interest rates is that monetary policy is expected to be tightened, future interest rates being expected to rise when the monetary authority restricts the availability of base money. That interpretation would also be consistent with the observed decline in inflation expectations.

For almost three weeks since Bernanke testified to Congress last month, hinting at the possibility that the Fed would begin winding down QE3, markets have been in some turmoil, and I conjecture that the turmoil is largely due to uncertainty caused by the possibility of a premature withdrawal from QE. This suggests that we may have entered into a perverse expectational reaction function in which any positive economic information, such as the better-than-expected May jobs report, creates an expectation that monetary stimulus will be withdrawn, thereby counteracting the positive expectational boost of the good economic news. This is the Sumner critique with a vengeance — call it the super-Sumner critique. Not only is the government-spending multiplier zero; the private-investment multiplier is also zero!

Now I really like this story, and the catchy little name that I have thought up for it is also cute. But candor requires me to admit that I detect a problem with it. I don’t think that it is a fatal problem, but maybe it is. If I am correct that real interest rates are rising because the odds that the Fed will tighten its policy and withdraw QE are increasing, then I would have expected that expectations of a Fed tightening would also cause the dollar to rise against other currencies in the foreign-exchange markets. But that has not happened; the dollar has been falling for the past few weeks, and the trend has continued for the last two days also. The only explanation that I can offer for that anomaly is that a tightening in US monetary policy would be expected to cause other central banks to tighten their policies even more severely than the Fed. I can understand why some tightening by other central banks would be expected to follow from a Fed tightening, but I can’t really understand why the reaction would be more intense than the initial change. Of course the other possibility is that different segments of the markets are being dominated by different expectations, in which case, there are some potentially profitable trading strategies that could be followed to take advantage of those differences.

It wasn’t so long ago that we were being told by opponents of stimulus programs that the stimulus programs, whether fiscal or monetary, were counterproductive, because “the markets need certainty.” Well, maybe the certainty that is needed is the certainty that the stimulus won’t be withdrawn before it has done its job.

PS I apologize for not having responded to any comments lately. I have just been swamped with other obligations.

News Flash: Real Interest Rates Are Turning Positive!

Published June 10, 2013 expectations , real interest rates 5 Comments
Tags: fiscal policy, May jobs report, QE

Just after I wrote my previous post about the recent decoupling of inflation expectations and the S&P 500, it was reported that the breakeven 10-year TIPS spread at the close of trading on Friday was a paltry 0.03%. But that 0.03% was a remarkable milestone, because the last time that 10-year TIPS spread closed above zero, was January 24, 2012, almost 18 months ago. At the close of trading on Thursday, the TIPS spread had been -0.05%. Friday’s jump of 8 basis points in the TIPS spread followed the announcement that 175,000 new jobs had been added in the US in May, more than expected given fears that continued fiscal tightening is now acting as a drag on the recovery. The S&P 500 rose by 18 points, over 1%, suggesting that the announcement was taken as a sign that net corporate cash flows would exceed previous expectations, which is how stock prices could rise despite being discounted at rising real rates.

And again today, real rates again rose by another 8%. However, the S&P 500 was essentially unchanged, which suggests that there was a slight further improvement in expectations of future net cash flows, but that these improvements were exactly offset by the increase in real discount rates. All in all, the expectational news for the past two business days seems mildly favorable. However, inflation expectations are continuing on their recent downward trend, so the prospect of a premature withdrawal from the Fed’s half-hearted QE program seems to be a cause for concern.

Say, it ain’t so, Ben!

What Gives? Has the Market Stopped Loving Inflation?

Published June 7, 2013 expectations , Fisher equation , inflation , monetary policy , QE 15 Comments
Tags: inflation expectations

One of my few, and not very compelling, claims to fame is a (still unpublished) paper (“The Fisher Effect Under Deflationary Expectations“) that I wrote in late 2010 in which I used the Fisher Equation relating the real and nominal rates of interest via the expected rate of inflation to explain what happens in a financial panic. I pointed out that the usual understanding that the nominal rate of interest and the expected rate of inflation move in the same direction, and possibly even by the same amount, cannot be valid when the expected rate of inflation is negative and the real rate is less than expected deflation. In those perilous conditions, the normal equilibrating process, by which the nominal rate adjusts to reflect changes in inflation expectations, becomes inoperative, because the nominal rate gets stuck at zero. In that unstable environment, the only avenue for adjustment is in the market for assets. In particular, when the expected yield from holding money (the expected rate of deflation) approaches or exceeds the expected yield on real capital, asset prices crash as asset owners all try to sell at the same time, the crash continuing until the expected yield on holding assets is no longer less than the expected yield from holding money. Of course, even that adjustment mechanism will restore an equilibrium only if the economy does not collapse entirely before a new equilibrium of asset prices and expected yields can be attained, a contingency not necessarily as unlikely as one might hope.

I therefore hypothesized that while there is not much reason, in a well-behaved economy, for asset prices to be very sensitive to changes in expected inflation, when expected inflation approaches, or exceeds, the expected return on capital assets (the real rate of interest), changes in expected inflation are likely to have large effects on asset values. This possibility that the relationship between expected inflation and asset prices could differ depending on the prevalent macroeconomic environment suggested an empirical study of the relationship between expected inflation (as approximated by the TIPS spread on 10-year Treasuries) and the S&P 500 stock index. My results were fairly remarkable, showing that, since early 2008 (just after the start of the downturn in late 2007), there was a consistently strong positive correlation between expected inflation and the S&P 500. However, from 2003 to 2008, no statistically significant correlation between expected inflation and asset prices showed up in the data.

Ever since then, I have used this study (and subsequent informal follow-ups that have consistently generated similar results) as the basis for my oft-repeated claim that the stock market loves inflation. But now, guess what? The correlation between inflation expectations and the S&P 500 has recently vanished. The first of the two attached charts plots both expected inflation, as measured by the 10-year TIPS spread, and the S&P 500 (normalized to 1 on March 2, 2009). It is obvious that two series are highly correlated. However, you can see that over the last few months it looks as if the correlation has been reversed, with inflation expectations falling even as the S&P 500 has been regularly reaching new all-time highs.

Here is a second chart that provides a closer look at the behavior of the S&P 500 and the TIPS spread since the beginning of March.

So what’s going on? I wish I knew. But here is one possibility. Maybe the economy is finally emerging from its malaise, and, after four years of an almost imperceptible recovery, perhaps the overall economic outlook has improved enough so that, even if we haven’t yet returned to normalcy, we are at least within shouting distance of it. If so, maybe asset prices are no longer as sensitive to inflation expectations as they were from 2008 to 2012. But then the natural question becomes: what caused the economy to reach a kind of tipping point into normalcy in March? I just don’t know.

And if we really are back to normal, then why is the real rate implied by the TIPS negative? True, the TIPS yield is not really the real rate in the Fisher equation, but a negative yield on a 10-year TIPS does not strike me as characteristic of a normal state of affairs. Nevertheless, the real yield on the 10-year TIPS has risen by about 50 basis points since March and by 75 basis points since December, so something noteworthy seems to have happened. And a fairly sharp rise in real rates suggests that recent increases in stock prices have been associated with expectations of increasing real cash flows and a strengthening economy. Increasing optimism about real economic growth, given that there has been no real change in monetary policy since last September when QE3 was announced, may themselves have contributed to declining inflation expectations.

What does this mean for policy? The empirical correlation between inflation expectations and asset prices is subject to an identification problem. Just because recent developments may have caused the observed correlation between inflation expectations and stock prices to disappear, one can’t conclude that, in the “true” structural model, the effect of a monetary policy that raised inflation expectations would not be to raise asset prices. The current semi-normal is not necessarily a true normal.

So my cautionary message is: Don’t use the recent disappearance of the correlation between inflation expectations and asset prices to conclude that it’s safe to abandon QE.

Japan Still Has Me Worried

Published June 3, 2013 currency manipulation , Scott Sumner 20 Comments
Tags: Abenomics, Bank of Japan

Last Thursday night, I dashed off a post in response to accusations being made by Chinese and South Korean critics of Abenomics that Japan is now engaging in currency manipulation. When I started writing, I thought that I was going to dismiss such accusations, because Prime Minister Abe has made an increased inflation target an explicit goal of his monetary policy, and instructed the newly installed Governor of the Bank of Japan to meet that target. However, despite the 25% depreciation of the yen against the dollar since it became clear last fall that Mr. Abe, running on a platform of monetary stimulation, would be elected Prime Minister, prices in Japan have not risen.

It was also disturbing that there were news reports last week that some members of the Board of Governors of the Bank of Japan voiced doubts that the 2% inflation target would be met.

Some of the members of the Bank of Japan (BOJ) board were doubtful about achieving the 2% inflation target projected by the bank within the two-year time frame, according to the latest minutes of the policy meeting.

Why a 25% decline in the value of the yen in six months would not be enough to raise the rate of inflation to at least 2% is not immediately obvious to me. In 1933 when FDR devalued the dollar by 40%, the producer price index quickly jumped 10-15% in three months.

Moreover, the practice of currency manipulation, i.e., maintaining an undervalued exchange rate while operating a tight monetary policy to induce a chronic current-account surplus and a rapid buildup of foreign-exchange reserves, was a key element of the Japanese growth strategy in the 1950s and 1960s, later copied by South Korea and Taiwan and the other Asian Tigers, before being perfected by China over the past decade. So despite wanting to defend the new Japanese monetary policy as a model for the rest of the world, I couldn’t conclude, admittedly based on pretty incomplete information, that Japan had not reverted back to its old currency-manipulating habits.

My expression of agnosticism invited some pushback from Scott Sumner who quickly fired off a comment saying:

I don’t follow this. Why aren’t you looking at the Japanese CA balance?

To which I responded:

Scott, Answer 1, CA depends on many things; FX reserves depends on what the CB wants. Answer 2, I’m lazy. Answer 3, also sleep deprived.

Well, I’m sticking with answer 1, but as I am somewhat less sleep deprived than I was last Thursday, I will just add this tidbit from Bloomberg.com

Japan‘s current-account surplus rose in March to the highest level in a year as a depreciating yen boosted repatriated earnings and brightened the outlook for the nation’s exports.

The excess in the widest measure of trade was 1.25 trillion yen ($12.4 billion), the Ministry of Finance said in Tokyo today. That exceeded the 1.22 trillion yen median estimate of 23 economists surveyed by Bloomberg News.

Prime Minister Shinzo Abe’s revamp of Japan’s central bank to focus on ending deflation paid off when the yen today slid past 101 for the first time since 2009, helping exporters such as Toyota Motor Corp. (7203), which now sees its highest annual profit in six years. Sustaining a current-account surplus may help to maintain confidence in the nation’s finances as Abe wrestles with a debt burden more than twice the size of the economy.

“The currency’s depreciation is buoying Japan’s income from overseas investment at a pretty solid pace,” said Long Hanhua Wang, an economist at Royal Bank of Scotland Group Plc in Tokyo. “A weaker yen provides support for Japanese exports.”

The cost of a weaker yen is higher import costs, reflected in a ninth straight trade deficit in March. The current-account surplus was 4 percent lower than the same month last year and the income surplus widened to 1.7 trillion yen, the highest level since March 2010, the ministry said.

So contrary to what one would expect if the depreciation of the yen were the result of an inflationary monetary policy causing increased domestic spending, thereby increasing imports and reducing exports, Japan’s current account surplus is approaching its highest level in a year.

Then, on his blog, responding to a commenter who indicated that he was worried by my suggestion that Japan might be engaging in currency manipulation, Scott made the following comment.

Travis, I had trouble following David’s post. What exactly is he worried about? I don’t think the Japanese are manipulating their currency, but so what if they were?

OK, Scott, here is what I am worried about. The reason that currency debasement is a good and virtuous and praiseworthy thing to do in a depression is that by debasing your currency you cause private economic agents to increase their spending. But under currency manipulation, the desirable depreciation of the exchange rate is counteracted by tight monetary policy designed to curtail, not to increase, spending, the point of currency manipulation being to divert spending by domestic and foreign consumers from the rest of the world to the tradable-goods producers of the currency-manipulating country. Unlike straightforward currency debasement, currency manipulation involves no aggregate change in spending, but shifts spending from the rest of the world to the currency manipulator. I don’t think that that is a good thing. And if that is what Japan is doing – I am not saying, based on one month’s worth of data, that they are, but I am afradi that they may be reverting to their old habits – then I think you should be worried as well.

Is Japan a Currency Manipulator?

Published May 30, 2013 currency manipulation , monetary policy 16 Comments
Tags: Abenomics, Bank of Japan, Martin Wolf

In his Wednesday column (“Japan’s bumpy road to recovery“) in the Financial Times, the estimable Martin Wolf provided a sober assessment of the recent gyrations of the Japanese bond and stock markets and the yen. I was especially struck by this passage.

[C]riticism over the decline in the yen is coming from abroad. Many, particularly in east Asia, agree with the warning from David Li of Tsinghua University that, far from a rise in Japanese inflation, “the world has merely seen a sharp devaluation of the yen. This devaluation is both unfair on other countries and unsustainable.” In a letter to the FT, Takashi Ito from Tokyo responded: “I just find it unbearable that countries that have debased or manipulated their currency can accuse Japan of depreciating the yen”. This does begin to look like a currency war.

In a couple of posts last November about whether China was engaging in currency manipulation, I first gave China a qualified pass and then reversed my position after looking a bit more closely into the way in which the Chinese central bank (PBoC) was imposing high reserve requirements on commercial banks when creating deposits, thereby effectively sterilizing inflows of foreign exchange, or more accurately forcing the inflow of foreign exchange as a condition for expanding the domestic Chinese money supply to meet the burgeoning domestic Chinese demand to hold cash.

So to answer the question whether Japan has been manipulating its currency to drive down the value of the yen, the place to start is to look at what has happened to Japanese foreign-exchange holdings. If Japan has been manipulating its currency, then the reduction in the external value of the yen would be accompanied by an inflow of foreign exchange. The chart below suggests that Japanese holdings of foreign exchange have decreased somewhat over the past six months.

However, this item from Bloomberg suggests that the reduction in foreign exchange reserves may have been achieved simply by swapping foreign exchange reserves for different foreign assets which, for purposes of determining whether Japan is manipulating its currency, would be a wash.

Japan plans to use its foreign- exchange reserves to buy bonds issued by the European Stabilitylity Mechanism and euro-area sovereigns, as the nation seeks to weaken its currency, Finance Minister Taro Aso said.

“The financial stability of Europe will help the stability of foreign-exchange rates, including the yen,” Aso told reporters today at a briefing in Tokyo. “From this perspective, Japan plans to buy ESM bonds,” he said. The purchase amount is undecided, Aso said.

The move may help Prime Minister Shinzo Abe temper criticism of Japan’s currency policies from trading partners such as the U.S. The yen has fallen around 8 percent against the dollar since mid-November on Abe’s pledge to reverse more than a decade of deflation as his Liberal Democratic Party won an election victory last month.

“The Europeans would be happy to see Japan buy ESM bonds, so Japan can avoid criticism from abroad and at the same time achieve its objective,” said Masaaki Kanno, chief economist at JPMorgan Securities Japan Co. and a former central bank official.

So I regret to say that my initial quick look at the currency manipulation issue does not allow me to absolve Japan of the charge of being a currency manipulator.

It was, in fact, something of a puzzle that, despite the increase in Japanese real GDP of 3.5% in the first quarter, the implicit Japanese price deflator declined in the first quarter. If Japan is not using currency depreciation as a tool to create inflation, then its policy is in fact perverse and will lead to disaster. It would also explain why doubts are increasing that Japan will be able to reach its 2% inflation target.

I hope that I’m wrong, but, after the high hopes engendered by the advent of Abenomics, I am starting to get an uneasy feeling about what is happening there. I invite others more skillful in understanding the intricacies of foreign exchange reserves and central bank balance sheets to weigh in and enlighten us about the policy of the BoJ.

What’s with Japan?

Published May 26, 2013 Ben Bernanke , monetary policy , Uncategorized 13 Comments
Tags: Japan, Wall Street Journal

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.

How Did Bernanke Scare the Markets?

Published May 23, 2013 Ben Bernanke , Federal Reserve , inflation , monetary policy 11 Comments
Tags: Bernanke, FOMC

On Wednesday Ben Bernanke appeared before the Joint Economic Committee of the US Congress to give his semi-annual report to Congress on the Economic Outlook. The S&P 500 opened the day about 1% higher than at Tuesday’s close, but by early afternoon had already given back all their gains, before closing 1% lower than the day before, an interday swing of 2%, pretty clearly caused by Bernanke’s testimony. The Nikkei average fell by 7%. Bernanke announced no major change in monetary policy, but he did hint that the FOMC was considering scaling back its asset purchases “in light of incoming information.” So what was it that Bernanke said that was so scary?

Let’s have a look.

Bernanke began with a summary of economic conditions, giving himself two cheers for recent improvements in the job market. He continued by explaining how, despite some minimal and painfully slow improvements, the job market remains in bad shape:

Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers’ skills and–particularly relevant during this commencement season–by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.

Bernanke then shifted to the inflation situation:

Consumer price inflation has been low. The price index for personal consumption expenditures rose only 1 percent over the 12 months ending in March, down from about 2-1/4 percent during the previous 12 months. This slow rate of inflation partly reflects recent declines in consumer energy prices, but price inflation for other consumer goods and services has also been subdued. Nevertheless, measures of longer-term inflation expectations have remained stable and continue to run in the narrow ranges seen over the past several years. Over the next few years, inflation appears likely to run at or below the 2 percent rate that the Federal Open Market Committee (FOMC) judges to be most consistent with the Federal Reserve’s statutory mandate to foster maximum employment and stable prices.

In other words, the job market, despite minimal improvements, is a disaster, and inflation is below target, and inflation expectations “continue to in the narrow ranges seen over the past several years.” What does that mean? It means that since the financial crisis of 2008, inflation expectations have consistently remained at their lowest levels in a half century. Why is any increase in inflation expectations above today’s abnormally low levels unacceptable? Bernanke then says that inflation appears likely to run at or below the 2% rate that FOMC believes is most consistent with the Fed’s mandate to foster maximum employment and stable prices. Actually it appears likely that inflation is likely to run below the 2% rate, perhaps by 50 to 100 basis points. For Bernanke to disguise the likelihood that inflation will persistently fail to reach the Fed’s own nominal 2% target, by artfully saying that inflation is likely to run “at or below” the 2% target, is a deliberate deception. Thus, although he is unwilling to say so explicitly, Bernanke makes it clear that he and the FOMC are expecting, whether happily or not is irrelevant, inflation to continue indefinitely at less than the 2% annual target, and will do nothing to increase it.

You get the picture? The job market, five and a half years after the economy started its downturn, is in a shambles. Inflation is running well below the nominal 2% target, and is expected to remain there for as far as the eye can see. And what is the FOMC preoccupied with? Winding down its asset purchases “in light of incoming information.” The incoming information is clearly saying – no it’s shouting – that the asset purchases ought to be stepped up, not wound down. Does Bernanke believe that, under the current circumstances, an increased rate of inflation would not promote a faster recovery in the job market? If so, on the basis of what economic theory has he arrived at that belief? With inflation persistently below the Fed’s own target, he owes Congress and the American people an explanation of why he believes that faster inflation would not hasten the recovery in employment, and why he and the FOMC are not manifestly in violation of their mandate to promote maximum employment consistent with price stability. But he is obviously unwilling or unable to provide one.

Why did Bernanke scare the markets? Well, maybe, just maybe, it was because his testimony was so obviously incoherent.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

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