Archive for March 2018


What should our public schools teach?

With Trump the ordinary rules don’t apply.  Mere scandals are hardly worth reporting—the GOP will protect him regardless of what’s he’s done.  But yesterday brought something a bit novel, even for Trump.

Trump lied to Canadian leader Justin Trudeau, claiming the US ran a trade deficit with Canada.

Then Trump joked about the fact that he lied to Trudeau.  It was caught on tape, and it was played on all the TV news shows.

Then he repeated the lie in a tweet.

If you want to claim that it’s not a lie, that we do have a trade deficit with Canada, you are faced with the following problem.  The “Economic Report of the President” signed by Trump, claims the US has a trade surplus with Canada.  So he’s either lying in the Economic Report of the President, or in his tweets.

All this supports Bryan Caplan’s case against public education.  One of the most common arguments for public schools is that they teach civics.  We need a well educated population so that we do not elect bad people.  And having gone through the public school system, I can vouch for the fact that they do teach civic virtue.  My teachers seemed to sincerely want us to be good people.  English classes taught us the importance of character.  In history and social science we learned about various figures who gained power through demagoguery, demonizing minorities, engaging in “the big lie”.  Lots of historical examples were cited.  Indeed if I think back to my middle and high school years, I’d sum up the education as basically emphasizing one point:

Under no circumstances should you ever, ever, ever consider electing a candidate like Donald Trump.

And yet we did.  He’s a textbook example of everything we were taught is bad.  The continual lying, the bullying, the corruption, the racism, the misogyny, the willful ignorance.  Either Trump is bad or public education is useless.

I vote for “both”.

Applying Occam’s Razor to the forward value of the yen

After my previous post, Brian McCarthy left the following remarks:

I believe there is a fair bit of empirical evidence that current spot rates are a better predictor of future spot rates than are current forward rates. So a naive “long carry” strategy does generate positive returns over time. The reason this “free money” isn’t arbitraged away, I would imagine, is that the strategy doesn’t have a good sharpe ratio. ie low returns relative to the volatility. In market slang it’s “picking up pennies in front of the steam roller,” involving a significant risk of ruin if done “in size.”

So the market really does “expect” the yen to be at 106 in 30 years, which is where it is today.

This is a good argument, but in the end I favor the alternative view.

Over the past 40 years, the US price level has risen from 1 to 3.975, while the Japanese price level has risen from 1 to 1.556. That means the US price level has risen by 2.555 relative to the Japanese price level.  Over the same period, the yen has appreciated from 241.37 to 106 to the dollar, a ratio of 2.227.  So the appreciation of the yen in the very long run is pretty close to the change predicted by PPP (although over shorter periods there are quite wide discrepancies.)

So here’s how I look at things.  The simplest explanation for the forward yen trading at 50 is that the public expects Japan to continuing having lower inflation than the US, just as has been the case for the past 40 years.  They expect the yen to continue appreciating, just as it has over the past 40 years.

The alternative explanation is possible, but involves more “epicycles”:

1.  Yes, the Japanese yen has been appreciating in the very long run.

2.  Yes, the Japanese inflation rate is consistently lower than in the US.

3.  Yes, the 30-year forward yen is trading at a strong premium, just as you’d expect if these trends were going to continue.

4.  But these facts are actually unrelated.  Starting right now, the Japanese inflation will suddenly rise to US levels, even though the markets don’t seem to expect that.  And starting right now the yen will stop appreciating.  And instead some other “real factor” explains why the forward yen is trading at a strong premium, some real factor that would cause 30-year Japanese real interest rates to be hundreds of basis points lower than American real interest rates.

That’s all theoretically possible, but isn’t the simplest explanation that the forward yen is at a strong premium because investors expect the spot yen to appreciate, and they expect the spot yen to appreciate for the same reason that it’s strongly appreciated over the past 40 years?

PS.  After I wrote this post (a few days ago), I discovered a similar post written earlier by Julius Probst, who has a very nice monetary economics blog.  He anticipates my basic point.  But read his post anyway, as it ends with some interesting remarks on Japanese monetary policy.


Money is fundamental, interest rates are secondary

Let’s try one more time, with the dollar/yen forward exchange rate.  I’d like to make the following assumptions.  It doesn’t matter whether you think these assumptions describe the real world; I’d simply like you to consider them as a hypothetical.  When we’re all done, we’ll think about what it means.

1.  Let’s assume the BOJ is determined to adopt a very tight money policy, over the next 30 years.  This policy will be so tight that the yen will end up valued at 50 to the dollar, more than double its current value.

2.  This very tight money policy causes very low inflation and very low NGDP growth in Japan.

So far interest rates don’t enter the picture, indeed interest rates need not even exist—imagine a world with no debt. I’m trying to make the appreciation of the yen into the fundamental shock, from which everything else flows.

3.  Now let’s add interest rates.  Because of the ultra-low expected inflation, and the ultra-low expected NGDP growth, nominal interest rates in Japan are more than 200 basis points below nominal interest rates in the US.  These low rates are caused by a tight money policy that leads to yen appreciation.

I’m still assuming the tight yen policy that leads to yen appreciation is fundamental, and everything else is an effect of that policy.

4.  Now let’s assume that the US and Japanese debt markets are very deep and liquid, and the 30-year forward yen contract is very lightly traded and not very liquid at all.  Let’s also assume that the forward premium on the yen is linked to the interest rate differential according to the covered interest parity theorem, although the theorem doesn’t work perfectly due to various market imperfections caused by regulations.  It’s roughly true.

I’m still assuming the tight yen policy that leads to yen appreciation is fundamental, and everything else is an effect of that policy.

Now let’s take stock of where were are.  Thus far, I have NOT claimed to describe the real world.  I’ve described a scenario where, by assumption, the huge forward premium on the yen drives the interest rate differential.  Quite possibly, this imaginary scenario has nothing to do with the real world.

But here’s the problem.  Not one commenter has given me a single fact that would lead me to conclude that this imaginary scenario does not in fact describe the real world.  Note, for instance, that I assumed that the two bond markets are highly liquid and traders focus on the interest rate spread.  I assumed the forward yen is lightly traded, and hence considered peripheral in the world of finance.  But I’ve also constructed an example where, by assumption, that difference in liquidity between the two markets has no bearing on causality.

So what would count as evidence against my imaginary scenario?  Perhaps you could convince me that while the 30-year forward yen is 50, traders actually expect the yen to be trading at 105 in the year 2048.  And investors continue to buy low yield JGBs in any case, because of market segmentation, or some other reason.  So the differences in interest rates are unrelated to differences in inflation, etc. If you offered that sort of explanation, and backed it up with evidence, I would be persuaded.  But I’m not seeing people do that.  Until then, I’m going to assume the causality goes from an appreciating yen to a situation where Japanese interest rates are lower than American interest rates.

PS.  The “carry trade” may partly explain why people disagree with me, but carry trades suffer from the “peso problem”, so I’m not convinced the carry trade will “work” going forward.  If Japanese inflation stays well below US inflation (as I expect), then the carry trade will break down at some point.

PPS.  Financial variables may or may not be linked to macro events.  The 1929 stock market crash seems to have been linked to fears of depression, while the 1987 stock market crash seems to have been sort of random.  You can view my claim here as being that the 1929 case is more typical.  Asset prices move based on shifting expectations regarding economic fundamentals.  Even if a forward exchange rate market did not exist, I’d claim that expectations of the future spot rate drive the interest rate differential.

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?