The Japan story: a lesson for central bankers everywhere

A James Alexander & Marcus Nunes post

It´s a simple story of failure, but one that fits the facts.

It´s also based on a simple premise: An inflation obsession that took hold in 1974.

It´s also a story that gives credence to Market Monetarists’ recommendation that central banks should level target NGDP.

It teaches us Abe´s latest move is one that goes in the right direction.

The story is told through 3 charts.

The trigger of the process that defined the Japanese economy was the domestic inflationary impact of the first oil shock. Inflation in 1974 climbed above 20% and worries about inflation and its effects on the real economy, including the worst bout of labor unrest since the war, quickly turned price stability into a priority of economic policy. More than a “priority”, price stability became an “obsession”. This is consistent with the reaction to the introduction of the consumption tax (CT) in 1989 and the CT increase in 1997.

We should put “price stability” in scare quotes too. The Fed and other central banks increasingly seem happy to interpret this as zero inflation is acceptable, but anything over 2% a precursor to hyperinflation at worst and a return to stop-go monetary policy chaos at best.

Japan Story_1

What central bankers should recognize are that labor unrest and consumption taxes are supply shocks and the best the BoJ could have done was keep NGDP on the level path it had been on since the early 50s. The BoJ monomania on price stability led to them wanting to “eradicate” inflation, not keep it in the 0% – 5% range that held in the 20 years before the oil shock. To do that, the BoJ strongly reduced the trend growth of NGDP. Did they think that crushing inflation would somehow teach labor a lesson? Perhaps.

The new trend held until 1990, when the “tax shock” gave a very short term uptick to inflation. Thereafter NGDP trend growth has remained close to zero. Competent central banks should stay loyal to long-term inflation expectations, but seem unable to do so only when headline inflation (even if due to CT increases) is above target. If headline or even core inflation is below target they all too easily fall back on those long term, well-anchored, expectations to justify doing nothing, or worse and tightening.

The BoJ´s goal of price stability (“zero” inflation) was attained, but real growth all but disappeared as monetary strangulation took place.

Japan Story_2

Abenomics, introduced with the election of Abe in late 2012, has improved things somewhat but it´s still tied the self-defeating inflation target (not “zero” but 2%), and as the recent experience of many developed countries with targets for inflation has shown, you can easily get into a “stagnation trap”!

Japan was the first country to (implicitly) pursue an inflation target. Now it looks on the verge of being the first to pursue an (explicit) NGDP level target. Maybe it will not take as long for present day inflation targeting countries to follow suit.

Who said there´s no irony in economic policy!

PS: The Economist makes exactly that suggestion:

A target for nominal GDP (or the sum of all money earned in an economy each year, before accounting for inflation) is less radical than it sounds. It was a plausible alternative when inflation targets became common in the 1990s. A target for NGDP growth (ie, growth in cash income) copes better with cheap imports, which boost growth, but depress prices, pulling today’s central banks in two directions at once. Nominal income is also more important to debtors’ economic health than either inflation or growth, because debts are fixed in cash terms.

What Monetary Policy Can and Cannot Do: Japan Edition

A Mark Sadowski post

Here’s Scott Sumner discussing the Japanese economy as an example of the Great Stagnation.

  1. In the 1st 4 quarters of Abenomics (i.e. 2013), RGDP grew by 2.4%, which we now know was a flat out boom.  Inflation rose into positive territory and the unemployment rate fell from 4.3% to 3.7%.
  2.  From the 4th quarter of 2013 to the 2nd quarter of 2015 the Japanese economy grew by a grand total of 0.1%.  And the unemployment rate continued to fall, from 3.7% to 3.4%. That’s right, over the past 6 quarters the Japanese economy has been growing at above trend.  But that blistering pace can’t go on forever.  The unemployment rate is down to 3.4%, and unless I’m mistaken there is a theoretical “zero lower bound” on unemployment that is even more certain than interest rates. The Japanese economy is like a Galapagos tortoise that has just sprinted 20 meters, and needs a long rest.”

Let’s take a look at the ten quarter moving average of RGDP growth in Japan. All data comes from the Japanese Cabinet Office.  (Pre-1994 data using 68SNA values has been chained to post-1994 data using 93SNA values.)

M Sadowski_Japan_1

It’s true, RGDP growth has only averaged 0.86% in the last ten quarters, which is nothing remarkable, even when compared to the low bar set by the average performance of the Japanese economy since 1993. (Also, keep in mind that virtually all of that real growth took place in the first four quarters of Abenomics.)

However, let’s look at the GDP implicit price deflator.

M Sadowski_Japan_2

Hmm, the GDP implicit price deflator has averaged 1.42% in the last ten quarters which is the highest rate since 1993Q2. Of course this might be due to the fact that the consumption tax was raised from 5% to 8% in April 2014, except that the consumption tax was also raised from 3% to 5% in April 1997 and that didn’t lead to a sustained increase in GDP implicit price deflator inflation.

There’s one way to settle this. Let’s look at NGDP growth.

M Sadowski_Japan_3

Yep, NGDP growth has averaged 2.27%, which is the highest rate since 1993Q3. That’s clearly not due to the consumption tax increase (that is, unless your model predicts that tax increases will be expansionary).

So it looks like the current round of Japanese QE has led to the greatest sustained increase in NGDP growth and GDP implicit price deflator inflation in 22 years, but it has only had an ephemeral effect on RGDP growth.

Where have I heard something like this before? Here’s Scott Sumner in 2011.

Just to be clear, it is quite possible (likely in my view) that Japan could get another 2% of RGDP by switching to a 3% NGDP target.  But it would be a one-time gain, as their labor market got less rigid.  Unemployment might fall to 2% or 3%, but trend growth shouldn’t change.

That sounds like an astute prediction to me.