In a recent post I suggested that severe demand shortfalls were also market predictions of severe demand shortfalls. In the comment section Larry quoted me and then asked an interesting question:
“But when it fails, it’s really, really hard to fix the problem, because doing so requires policymakers to be more effective than the markets predict. I won’t say that things are hopeless when markets predict disaster, but I wouldn’t put much hope on stabilization policy.”
This seems quite fatalistic. So if the monetary authority blows it there is nothing to be done? Does this pessimism apply to both monetary and fiscal policy?
Yes, it applies to both monetary and fiscal, but it’s important to distinguish between two types of difficulty:
1. In both the 1930s and the 2010s the markets believe that monetary stimulus is very easy to do in a technical sense. Asset prices rally strongly on even rather small stimulus measures from the central bank.
2. Asset markets tend to be very pessimistic about the prospects for reflation after monetary policy has had a severe failure. This suggests that markets believe the political barriers to reflation are formidable.
Japan is a perfect case study. Asset markets took off after mid-November 2012, when then candidate Abe first indicated he was going to push for a 2% inflation target. The yen fell from about 80 to the dollar to 103 today, while the Nikkei rose from under 8700 to over 15,300 today. So the asset price gains have been sustained. And we did see a rise in the Japanese price level, RGDP and NGDP. So in one sense Abenomics “worked.”
On the other hand the Japanese 10 year bond yield is 0.51%, vs. 2.50% in the US, and the 30 year bond yield is 1.67%, vs. 3.30% in the US. That tells me that the bond market probably expects Japanese inflation to remain well below US levels in the long run, perhaps close to zero. And that suggests that Japanese asset markets believe that the political obstacles remain formidable. After all, Abe won’t be the prime minister forever.
And yet if the BOJ did another round of stimulus—enough to push the yen down to 120, there is little doubt that stocks would rally again and GDP growth would pick up (at least nominal, and probably real as well.) The problems are political, not technical.
Here’s an analogy. The 1924 British expedition to Everest failed to achieve the summit, but did get a couple men above 28,000 feet—a great achievement in those days. (Unfortunately several died.) So was it a failure or a success? A bit of both. Successes were achieved, but it failed to achieve the announced goal.
Of course mountain climbing is not a perfect analogy, as in 1924 people would have laughed if anyone argued that debasing a currency was “difficult” (Germany’s price level rose over a billion fold between 1920 and 1923.) Again, the difficulties are political, not technical.
Of course asset markets are often wrong, and they might well be wrong about Japan. It’s also possible that the bond yields are not a forecast of Japanese inflation being much lower than in the US. (I was not able to find long term forward rates for the yen, and don’t even know if interest parity holds in this case.)
MMs believe that market forecasts are the best we have. Thus I immediately saw that the policy “worked” in a limited sense, because announcements repeatedly affected asset prices, but also immediately saw the long term doubts about the BOJ’s willingness to carry through with its promises.
A near perfect analogy is the dollar depreciation program of 1933. FDR abandoned it before hitting his announced price level target (returning prices to pre-depression levels) under intense political pressure. But it did achieve some important limited objectives. The stock market rally was comparable to the recent Japanese rally.
So my overall views on Japan are mixed. I view the depreciation of the yen and the huge stock market rally as signals that the Abe government overcame formidable political odds. Good for them. I view the low bond yields as a sign that the markets now expect the BOJ to rest on its laurels, and not try to push the price level even higher. That’s not so good. The labor market is no longer the biggest problem in Japan; it’s the debt situation. As long as nominal interest rates are near-zero the BOJ is needlessly worsening Japan’s long term fiscal situation.
Don’t pay any attention to GDP, which soared in Q1 and will plunge in Q2. The forex rate and stock prices are the best short term indicator of how the BOJ is doing. If the yen moves into the 110 to 120 range, that would suggest my political forecast was too pessimistic. If it moves below 95, I was too optimistic.
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