Archive for March 2018


Why is the 30-year forward yen at about 50 to the dollar?

Nick Rowe likes to teach PPP with a thought experiment, asking students to imagine how they might guess an exchange rate between the dollar and a foreign currency.  Thus if you went to Japan and noticed that most prices seem to be about 100 times higher than in the US, you might guess that 100 yen equals one dollar.  Of course PPP often does not hold true, but it’s still probably the best first guess for the exchange rate, if you had absolutely nothing else to go on.

In that case, it is more useful to think of the exchange rate being caused by the Japanese price level being 100 times higher than in the US?  Or should we think about the price level difference being caused by the exchange rate?  Is this even a meaningful question?

I like to think about the two price levels as being in some sense more fundamental, as I could imagine a case with no contract between the two countries.  Then once contact is made by Commodore Perry, the exchange rate conforms to the pre-existing price levels.  But you can also imagine a new country being settled by England, and choosing to use the dollar rather than the pound.  In that case the two price levels would be determined by the choice of the exchange rate.  The adoption of the euro is an obvious recent example, which caused Italian prices to plummet dramatically.

In a recent comment section I’ve discussed the fact that the 30-year forward dollar trades at roughly 50 yen (actually 49.332).  Is that exchange rate caused by the interest rate differential, or is the interest rate differential caused by the forward exchange rate?  People in the financial markets may focus on interest rate differentials as the primary factor, as the 30-year forward exchange rate is not very liquid and seems to be roughly 50Y/$ merely to prevent easy arbitrage opportunities, given the interest rate differential.

[I tried to see if interest parity held, but I don’t know the interest rate on 30-year zero coupon bonds.  So I took the yields on actual 30-year bonds as a proxy.  The US 30-year bond yields 3.17% and the Japanese bond yields 0.747%.  The differential is 2.423%.  Then I took 1.02423, and raised it to the 30th power, which equals 2.0508.  Then I took the actual exchange rate of 106.17, and divided by 2.0508, and got 51.77 as the implied 30-year forward yen. Is that right?]

In my view, it makes more sense to think of the expected 30-year forward exchange rate of 50 as the fundamental factor, and the interest rate differential as contingent on that expected future exchange rate.  Conversely, consider what would happen if we were to start with the interest rate differential as fundamental.  Then thinking in terms of interest rates, what would the BOJ have to do to prevent the yen from getting so strong in 30 years?  Obviously they need to make monetary policy more expansionary.  That’s how you weaken a currency.  But how do you do that in terms of the interest rate differential?  Obviously you need to get rid of the interest rate differential if you want the yen to be worth roughly 106 out in the year 2048.  But how do you get rid of the interest rate differential, while making monetary policy much more expansionary?

Let’s assume the BOJ cannot do anything about the level of interest rates in the US.  If they want the yen to be worth 106Y/$ in the year 2048, they need to get Japanese interest rates up to 3.17% on 30-year Japanese government bonds.  Even more daunting, they must do so with a highly expansionary monetary policy.  (Cochrane and Williamson are smiling at this point.)

So how do you do that?  Normally, a decision to raise interest rates is treated by the financial markets as a tight money policy, which causes the currency to appreciate.  So the BOJ needs to get interest rates up to 3.17% on 30-year bonds, and keep the exchange rate close to 106Y/$.  So how do they do that?  The simplest solution is to go back to Bretton Woods, and peg the yen to the dollar at 106.  If credible, that will cause Japanese 30-year bond yields to rise to 3.17%, and after 30 years the exchange rate will still be 106.  Because of PPP, Japan’s inflation rate over the next 30 years probably won’t be much different from the US inflation rate.  More importantly, the current expected inflation rate will rise to roughly 2%, just as in the US.

The fact that investors now expect the yen to be trading at about 50Y/$ in 2048 tells you just how far away from success the BOJ remains.  This is why I say that any talk of exiting from monetary stimulus is crazy.  Monetary policy in Japan remains extremely tight, expected to produce very low inflation over the next 30 years.  They need more than tinkering; they need a dramatic regime change.  I don’t advocate a fixed exchange rate system, but that’s one example of a radical regime change that would “work”.  A better option might be level targeting, combined with a “do whatever it takes” approach to monetary policy implementation.  I.e. buy as many assets as needed to get prices or NGDP rising along the desired level targeting path.

We don’t have that regime today, which makes the 30-year forward yen a useful proxy for policy credibility.  Only when the 30-year forward yen rises far above the current level of 50 can the BOJ start relaxing.  The BOJ has had some success in boosting prices and NGDP, but very little success in convincing the markets that this policy will continue in the very long run.  It seems like markets believe that once Abe is gone the BOJ will revert to its old habits.

PS.  If the regime change is credible they won’t have to buy very many assets.

Japan doesn’t have easy money, but it needs it

Sometimes you can only shake your head at the confusion surrounding monetary policy.

The BOJ has a set a 2% inflation target.  While inflation has risen a little bit, it’s still well short of the target.  More importantly, market indicators suggest that Japan is unlikely to hit the 2% target going forward.  Thus this story makes no sense:

“The BOJ’s board members expect that prices will reach 2 percent around fiscal 2019. If this happens, there’s no doubt that we will consider and debate an exit,” Bank of Japan Governor Haruhiko Kuroda told parliament.

Can someone explain to me why the BOJ would believe that inflation will soon hit 2%? Ten-year bond yields are currently close to zero, vs, 2.9% in the US.

With prolonged easing straining bank margins, some analysts have called on the BOJ to raise rates before inflation hits 2 percent, arguing that it was too high a level to aim for in a country that has suffered from two decades of deflation.

If the BOJ tightens policy by raising rates before hitting 2% inflation, within a year or two they’ll be back down to zero.

PS.  Can someone tell me if I’m reading this table correctly?  Are forward discounts on the dollar quoted in basis points?  Does this table imply the 30-year forward dollar is trading at only about 50 yen?

You knew this was coming

Why am I not surprised?

Chinese President Xi Jinping recently consolidated power. Trump told the gathering: “He’s now president for life. President for life. And he’s great.” Trump added, “I think it’s great. Maybe we’ll give that a shot someday.”

There are a lot of people in China who believe in classical liberal principles.  At one time they respected America.

PS.  If you think presidential character doesn’t matter, read this.

PPS.  I just crossed 10,000,000 views:


Is Mexico now targeting the forecast?

Commenter HL directed me to this slide from a presentation by the Mexican central bank:

HL suggested that this meant the Bank of Mexico is now “targeting the forecast”.  It does sort of suggest that policy is being adopted, but it’s hard for me to be sure.  Any comments would be welcome.

Let’s recall the mistakes made by the Fed in 2008:

1. Too much weight on inflation, too little on NGDP growth.

2. Growth rate targeting rather than level targeting.

3.  Failure to target the forecast (as well as too little reliance on market forecasts.)

4.  Failure to do “whatever it takes”.

That seems like a lot, but fixing some of these problems makes the other issues much less of a problem.  Addressing problem #2 alone, or #4 alone, would have gone a long way toward making the 2007-09 recession much less “Great”.

When combined with David Beckworth’s recent post on level targeting, I’m becoming more optimistic about global trends in monetary policy.

The nationalists’ dilemma

Donald Trump and other members of the alt-right tend to have a very favorable view of Vladimir Putin.  After all, he shares many of their nationalistic political instincts.  But nationalists face a dilemma, as their ideology is fundamentally selfish.  Nationalists favor the home country and demonize foreigners.  So are nationalists to be pro-America or pro-nationalism?  You can’t have it both ways.

In recent years, Putin has brought back the Cold War, by invading neighboring countries, tearing up arms control agreements and gloating about the fact that the US will not be able to stop a new type of nuclear missile from reaching Florida.  Trump doesn’t seem to know how to respond to this new reality:

Former CIA Director John Brennan expressed “deep worry and concern” Friday about leadership and the nation’s safety in the wake of Donald Trump’s ugly Twitter attack against Alec Baldwin over the actor’s portrayal of the president on “Saturday Night Live.”

Brennan was asked by Nicolle Wallace on MSNBC if he thought Trump was “too unstable” to possess the nuclear codes that would allow him to launch an attack. Brennan responded that he was rattled by the president’s strange focus on Baldwin the morning after Russian President Vladimir Putin boasted of his nation’s nuclear capabilities to strike anywhere in the world, including the U.S. A simulated video presented by Putin appeared to depict next-generation nuclear missiles striking Florida.

Trump has yet to respond to Putin. Instead, he ranted against the actor in an error-riddled tweet early Friday morning (the tweet was later reposted with corrections).

“When I hear what Vladimir Putin was saying about the nuclear capabilities he has [and] then the president of the United States is tweeting about Alec Baldwin this morning, I mean, where is your sense of priorities?” Brennan asked. “I think a lot of Americans are looking at what’s happening with a sense of: This is surreal.”

There’s “deep, deep worry and concern for this country’s national security,” he added.

A couple days ago I visited the Nixon Library in Yorba Linda.  The Nixon administration is the first one that I remember well, and seeing the exhibits brought back a lot of memories.  I view Nixon as one of America’s worst presidents.  He was very corrupt and dishonest.  And yet, he was so far superior to Trump that it’s like they are not even members of the same species.  Even in Nixon’s worst qualities, he was nowhere near as bad as Trump; not nearly as corrupt or dishonest, for instance. (John Dean recently made the same point.)  And in his best qualities he was dramatically superior to Trump.  He worked hard, gave a lot of thought to foreign affairs, and did seriously try to improve our relations with countries such as China and the Soviet Union.  Watching news clips from that era you had the sense that America was actually a serious country, like Canada or Germany or the Netherlands.  Now this country seems like just another banana republic, with a president who has the mentality of a Duterte, a Chavez, a Berlusconi.  It is a surreal experience viewing the Nixon Library with the thought of Trump in the back of one’s mind.

Update:  And isn’t this reassuring?