What the markets are telling us about Japan
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.
PS. Matt Yglesias points out the absurdity of Obama touting the strong jobs market. But Yglesias’s post is marred by an unwillingness to mock Obama for saying this while also arguing for bringing back the emergency unemployment insurance program–intended for lousy job markets.
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5. August 2014 at 09:11
10 year inflation-linked bonds in Japan are priced suggesting a market forecast of 1.2%.
5. August 2014 at 10:32
Hi Scott, once again I think your attempt to weave the bond market and stock market reactions into a narration that fits your worldview is unsatisfying, this time in Japan. The disparate reactions of the Japanese bond/and stock markets to Abenomics is interesting, but I don’t think it is easily or even plausible explained by your story of short-term-good-but-long-term-politically-doomed. This is even more true when you look more closely at the event reactions of each market. Much like in the US, it probably takes the sort of nuance that either dents or introduces frictions into an EMT story to really weave these markets together into something edifying — especially wrt the relative behavior of these markets in spring of 2013 and over the last several weeks.
The 10 year forward yen is 78.
5. August 2014 at 11:24
Thanks effem.
dlr, Can you be more specific? Which of my comments did you think were not supported by market reactions? BTW, the 10 year forward value of the yen is consistent with what I argued, and not consistent with the goals of Abenomics.
5. August 2014 at 12:05
If the NKY is up to 15,000 and the JGB10 goes from 80bps to 180bps then markets are telling us that its is working to raise nominal expectations, which in turn is expected to improve the economy. If the NKY is flat at 9000 and the JGB yield declines from 80bps to 50bps then markets are telling us it is not working to raise nominal expectations in the first place. If the JGB goes up to 180 and the NKY is down to 5000 markets are telling us it is working to raise nominal expectations (let’s assume Japan CDS are flat) but that there is no nominally-driven output gap. Here, where the NKY is up to 15K but the JGB10 yield declines to 50bps, markets are telling us that Abenomics is working but has “political obstacles?” Why do political obstacles result in a lower breakeven and lower real rates but a NKY 75% higher? Doesn’t the NKY care about the political obstacles that are so great that the bond market actually expect nominal contract relative to pre-Abenomics?? Hard to pinpoint that equilibrium unless you are telling a just-so story to fit the data. If I had told you about Abenomic in advance and also showed you a chart of the JGB10, I don’t think your best guess is that the NKY is up 75%! So I think what markets are telling us about Japan is much tougher than you imply in this post.
5. August 2014 at 12:07
Prof. Sumner,
Do you have anything more to write about that Woodford interview?
5. August 2014 at 14:02
Goldman: A ‘Dramatic Divergence’ Is Coming To Stocks And Bonds
“Factoring in the impact of the Fed raising interest rates “” which Goldman’s economics team expects to happen in the third quarter of 2015 “” Kostin and his team expect the real return for stocks to be 4% annualized while bonds will return -1% annualized over the “next several years.””
http://www.businessinsider.com/goldman-divergence-coming-stocks-bonds-2014-8
5. August 2014 at 14:12
Richard Fisher: FOMC Moving Toward Hawkish Stance
http://blogs.wsj.com/economics/2014/08/05/feds-fisher-fomc-moving-toward-hawkish-stance/?mod=WSJBlog
5. August 2014 at 16:23
Eliminating the wrong goods from production, and replacing them with producing the right goods, which does not require any change in aggregate money supply or demand, will naturally encourage increased money demand out of the already more than plentiful supply of money.
The reason MMs keep perceiving tight money everywhere is because their theory is blind to real malinvestment.
On an unrelated note, the employment number is reported as much greater than it actually is, due to the “birth/death” statistical adjustment that has not changed since 1960, despite this:
http://www.brookings.edu/~/media/research/files/papers/2014/07/aging%20america%20increasing%20dominance%20older%20firms%20litan/other_aging_america_dominance_older_firms_hathaway_litan.pdf
5. August 2014 at 17:01
The following chart’s data is consistent with, but does not prove, the theory that tighter money even as MMs define it, is associated with rising interest rates, and looser money even as MMs define it, is associated with falling interest rates:
http://research.stlouisfed.org/fred2/graph/?g=H7e
5. August 2014 at 21:16
Do you think it would be a good idea if the fed had a primary and secondary target? Primary target ngdp and secondary inflation. If the fed achieved 5% ngdp growth and this was resulting in 1% inflation the ngdp target could be increased to 8% to achieve 2% inflation.
It would be sort of like targeting real gdp.
6. August 2014 at 01:27
Scott,
A few things.
1. I think you can not analyze the current Japanese economic situation absent an explanation of the consumption tax increase and without knowing BOJ’s policy response to it. They may just be waiting for data.
2. As you well know, equity prices are not a very good indicator of overall financial asset price unless you normalize for expected changes in corporate profits.
3. Similarly, you can’t conclude much about the stance of monetary policy from changes in bond prices unless you know how expected NGDP has changed.
4. The relationship between NGDP and RGDP has always been different in Japan than in the U.S. so I don’t think you can conclude much from comparisons with nominal U.S. bond yields.
5. Japanese politicians keep muddying the water by saying a goal of inflation is nominal wage increases. The whole point of monetary policy in a downturn is to lower real wages. If you didn’t have sticky wages/prices, there would be no need for monetary policy.
6. IMHO, hysteresis plays a major role in inflation. With 20 years of stable prices or declining prices, even with increased economic activity, the RGDP/NGDP gap might be pretty small. Nominal bond yields might be anticipating higher RGDP with no pickup in inflation.
7. There may be some institutional factors impacting the JGB market. It would be worthwhile to look at spreads between JGB and Japanese corporate bond yields.
6. August 2014 at 02:08
Reading anything into JGB (or JGBi) yields currently is futile. As a macro trader and observer based in Asia, who spends a lot of time in Japan, it is pretty clear that the market is at a false price. The Japanese have a well known demographic bias that means lots of savings are tied up in Pensions, Life Insurers which have to hold JGBs for ALM reasons, plus the banks are subject to the Basel III type restrictions that mean they need to keep a certain amount of JGBs to hand. Then the BOJ is furiously buying and purposefully keeping real yields negative, thus the secondary market has become very illiquid. Sometimes supply and demand in rates markets is not about economics, but policy.
6. August 2014 at 05:32
50% of the Japanese equity market volume is by foreign firms — they bought the Abe story (or at least thought they could resell it) and the Nikkei rallied, less so in USD terms. On the other hand, the JGB market is overwhelmingly domestic and the addition of the BOJ vacuum cleaner drove down yields. A very large chunk of the JGB new issuance is being immediately flipped to the BOJ at a generous markup. There are days when JGBs don’t trade *at all* — in the second largest sovereign market in the world! And imagine you’re an asset manager who’s done nothing but buy JGBs for the past 20 years. Are you going to all of a sudden change your behavior, or will inertia have an affect on you? I don’t think there’s any information about expected inflation in such a market. It’s all political: best case, the government generates genuine growth; but at the least, in 10 years they end up with a lower real debt burden thanks to financial repression. Today in Japan realized inflation is measured in percent, while short term yields are measured in basis points. There will be winners and losers in the society, but the government will survive.
6. August 2014 at 05:47
I do not speak or read Japanese. So I wonder does the Bank of Japan also have a board, akin to the FOMC, upon which members sit and pontificate on the perils of inflation and rhapsodize about the virtues of deflation? if so the market may be responding to the loudmouths on the Japanese equivalent of the FOMC.
6. August 2014 at 06:19
The structure of the BOJ may matter somewhat, or the amount of chatter, but basic political realities would remain the same either way: no matter what Abe and Kuroda say, ‘everyone’ knows that if the result of their monetary policy was ‘off target’ in a variety of ways thier response would likely not be as stated. For example: if rgdp growth picks up modestly but ngdp growth (or inflation) remain below target they will be satisfied. If ngdp growth (or inflation) is on target but gdp growth does not pick up at all, their policies will quickly be abandoned despite being ‘on target’. This realitity of political expectations translates into a real divergence between the BOJs expected response function and their stated one. This divergence is doubtless represented in the market–whether the magnitude of that effect is swamped by factors like the random walk is up for debate, but objections like demography and culture are contained within professor sumner’s vague (I mean that in a good way) use of the term ‘political obstacles’.
6. August 2014 at 06:27
M.F
Thanks for the Brooking link. Very interesting data.
6. August 2014 at 07:11
Gundlach: The Fed May Have To Resurrect Quantitative Easing By 2020
“One reason the Fed may have to resurrect quantitative easing by then, Gundlach said, is that investors seem to be deluded about growth prospects. They all cling to the notion of “escape velocity,” he said, “and then all of a sudden they won’t.” Gundlach still doesn’t expect 2014 GDP to exceed 2% for the full-year.
Foley’s whole interview is well worth a read, providing yet another bit of insight into the mind of one of the most important people in the bond market.”
http://www.businessinsider.com/gundlach-sees-qe-coming-back-in-2020-2014-8
6. August 2014 at 09:43
dlr, I think you missed the point. I said monetary stimulus did raise NGDP, hence the higher stock market, but didn’t significantly boost the long run trend, hence the low long term bond yields. The two markets do not measure the same thing. It’s a question of levels vs. rates of change.
travisA, I don’t recall the interview, was there something specific to comment on?
CMA, I strongly oppose targeting RGDP.
dtoh, I agree with most of your comments, but am a bit confused by 4 and 6.
Kinkoji and Jason, Yes, as I said in the post that market is not a perfect forecast of inflation. But we also have other evidence. Long term forward yen contracts are strong, and private sector forecasts of inflation are well below 2%.
Nick, Unfortunately I think you are right.
Travis, I agree that QE will return at some point. They still haven’t learned their lesson.
6. August 2014 at 10:27
Travis,
Richard fisher is a despicable, idiotic human being
6. August 2014 at 16:59
Scott,
To summarize 4) and 6), I think you might need a fair amount of RGDP growth to get any pickup in inflation.
7. August 2014 at 00:27
I think you might need a fair amount of RGDP growth to get any pickup in inflation.
Do puddles on the ground cause rain ?
7. August 2014 at 03:18
Do puddles on the ground cause rain ?
Eventually.
7. August 2014 at 03:24
Edward,
I agree!
7. August 2014 at 09:31
dtoh, I prefer to think in terms of NGDP causing both RGDP and inflation.
10. August 2014 at 03:21
Scott,
IME, it’s an imbalance in expected real supply and demand that causes inflation… but there are different ways of thinking about it.