In the blog Japan’s interesting monetary policy as deflation fears grow we detailed the aggressive monetary measures of Japan’s central bank to prevent a deflationary mindset becoming again established. In January it introduced a negative interest rate on some deposits placed with it by commercial banks. This is in addition to it massive quantitative easing programme to boost the country’s money supply. Despite this, the latest consumer price inflation data show inflation now running at zero per cent.
As the chart shows, since the mid 1990s there have been protracted periods of Japanese price deflation (click here to download a PowerPoint file of the chart). In January 2013 Japan introduced a 2 per cent CPI inflation target. This was accompanied by a massive expansion of its quantitative easing programme, through purchases of government bonds from investors.
Following this substantial monetary loosening, buoyed too by a loosening of fiscal policy, the rate of inflation rose. It reached 3.7 per cent in May 2014.
However, through 2015 the rate of inflation began to fall sharply, partly the result of falling commodity prices, especially oil. The latest inflation data show that the annual rate of CPI inflation in January 2016 fell to zero percent. In other words, consumer prices were on average at the levels seen in January 2015.
The latest inflation numbers appear give further credence to the fear of the Bank of Japan that deflation is set to return. The introduction of a negative deposit rate was the latest move to prevent deflation. As well as encouraging banks to lend, the move is intended to affect expectations of inflation. By adopting such an aggressive monetary stance the central bank is looking to prevent a deflationary mindset becoming re-established. Hence, by increasing the expectations of the inflation rate and by raising wage demands the inflation rate will rise.
The loosening of monetary policy through a negative interest rate follows the acceleration
of the quantitative easing programme announced in October 2015 to conduct Open Market Operations so as to increase the monetary base annually by ¥80 trillion.
The decline of Japan’s inflation rate to zero may yet mean that further monetary loosening might be called for. Eradicating a deflationary mindset is proving incredibly difficult. Where next for Japan’s monetary authorities?
Data
Consumer Price Index Statistics Bureau of Japan
New Articles
Japan’s inflation drops to zero in January MarketWatch, Takashi Nakamichi (25/2/16)
Japan inflation falls back to zero in January: govt AFP (26/2/16)
With pause in inflation, many brace for retreat Nikkei Asian Review (27/2/16)
Japan’s inflation rate has fallen again – to 0% Business Insider Australia, David Scutt (26/2/16)
Previous Articles
Bank of Japan adopts negative interest rate policy CNBC, Nyshka Chandran (29/1/16)
Japan adopts negative interest rate in surprise move BBC News (29/1/16)
Bank of Japan shocks markets by adopting negative interest rates The Guardian, Justin McCurry (29/1/16)
Japan stuns markets by slashing interests rates into negative territory The Telegraph, Mehreen Khan (29/1/16)
Japan introduces negative interest rate to boost economy The Herald, (29/1/16)
Questions
- What is deflation?
- What are the dangers of deflation? Why is the Bank of Japan keen to avoid expectations of deflation becoming re-established?
- To what extent are national policy-makers able to exert pressure over the rate of inflation?
- What does a negative interest rate on deposits mean for depositors?
- What effect is the Bank of Japan hoping that a negative deposit rate will have on the Japanese economy? How would such effects be expected to occur?
- What effect might the Bank of Japan’s actions be expected to have on the structure of interest rates in the economy?
- How might the negative interest rate effect how people wish to hold their wealth?
In an attempt to prevent recession following the financial crisis of 2007–8, many countries adopted both expansionary monetary policy and expansionary fiscal policy – and with some success. It is likely that the recession would have been much deeper without such policies
But with growing public-sector deficits caused by the higher government expenditure and sluggish growth in tax receipts, many governments soon abandoned expansionary fiscal policy and relied on a mix of loose monetary policy (with ultra low interest rates and quantitative easing) but tight fiscal policy in an attempt to claw down the deficits.
But such ‘austerity’ policies made it much harder for loose monetary policy to boost aggregate demand. The problem was made worse by the attempt of both banks and individuals to ‘repair’ their balance sheets. In other words banks became more cautious about lending, seeking to build up reserves; and many individuals sought to reduce their debts by cutting down on spending. Both consumer spending and investment were slow to grow.
And yet government and central banks, despite the arguments of Keynesians, were reluctant to abandon their reliance solely on monetary policy as a means of boosting aggregate demand. But gradually, influential international institutions, such as the IMF (see also) and World Bank, have been arguing for an easing of austerity fiscal policies.
The latest international institution to take a distinctly more Keynesian stance has been the Organisation for Economic Co-operation and Development (OECD). In its November 2015 Economic Outlook it had advocated some use of public-sector investment (see What to do about slowing global growth?. But in its Interim Economic Outlook of February 2016, it goes much further. It argues that urgent action is needed to boost economic growth and that this should include co-ordinated fiscal policy. In introducing the report, Catherine L Mann, the OECD’s Chief Economist stated that:
“Across the board there are lower interest rates, except for the United States. It allows the authorities to undertake a fiscal action at very very low cost. So we did an exercise of what this fiscal action might look like and how it can contribute to global growth, but also maintain fiscal sustainability, because this is an essential ingredient in the longer term as well.
So we did an experiment of a two-year increase in public investment of half a percentage point of GDP per annum undertaken by all OECD countries. This is an important feature: it’s everybody doing it together – it’s a collective action, because it’s global growth that is at risk here – our downgrades [in growth forecasts] were across the board – they were not just centred on a couple of countries.
So what is the effect on GDP of a collective fiscal action of a half a percentage point of GDP [increase] in public investment in [high] quality projects. In the United States, the euro area, Canada and the UK, who are all contributors to this exercise, the increase in GDP is greater than the half percentage point [increase] in public expenditure that was undertaken. Even if other countries don’t undertake any fiscal expansion, they still get substantial increases in their growth rates…
Debt to GDP in fact falls. This is because the GDP effect of quality fiscal stimulus is significant enough to raise GDP (the denominator in the debt to GDP ratio), so that the overall fiscal sustainability [debt to GDP] improves.”
What is being argued is that co-ordinated fiscal policy targeted on high quality infrastructure spending will have a multiplier effect on GDP. What is more, the faster growth in GDP should outstrip the growth in government expenditure, thereby allowing debt/GDP ratios to fall, not rise.
This is a traditional Keynesian approach to tackling sluggish growth, but accompanied by a call for structural reforms to reduce inefficiency and waste and improve the supply-side of the economy.
Articles
Osborne urged to spend more on infrastructure by OECD Independent, Ben Chu (18/2/16)
OECD blasts reform fatigue, downgrades growth and calls for more rate cuts Financial Review (Australia), Jacob Greber (18/2/16)
OECD calls for less austerity and more public investment The Guardian, Larry Elliott (18/2/15)
What’s holding back the world economy? The Guardian, Joseph Stiglitz and Hamid Rashid (8/2/16)
OECD calls for urgent action to combat flagging growth Financial Times, Emily Cadman (18/2/16)
Central bankers on the defensive as weird policy becomes even weirder The Guardian, Larry Elliott (21/2/16)
Keynes helped us through the crisis – but he’s still out of favour The Guardian, Larry Elliott (7/2/16)
G20 communique says monetary policy alone cannot bring balanced growth
Reuters (27/2/15)
OECD publications
Global Economic Outlook and Interim Economic Outlook OECD, Catherine L Mann (18/2/16)
Interim Economic Outlook OECD (18/2/16)
Questions
- Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
- Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
- Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all OECD countries rather than being the only country to pursue such a policy?
- What determines the size of the multiplier effect of such policies?
- How might a new classical/neoliberal economist respond to the OECD’s recommendation?
- Why may monetary policy have ‘run out of steam’? Are there further monetary policy measures that could be adopted?
- Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
- Should quantitative easing be directed at financing public-sector infrastructure projects? What are the benefits and problems of such a policy? (See the blog post People’s quantitative easing.)
The perceived wisdom is that nominal interest rates have a lower zero bound. The Swedish central bank (the Ricksbank) has effectively been charging financial institutions to deposit money at the central bank since 2009. On 29 January 2016 the Central Bank of Japan also introduced a negative interest rate on deposits. The -0.1 per cent rate currently applies to a portion of the reserves held by financial institutions at the central bank. The move is another attempt to pump energy into a struggling economy.
As the chart shows, since the mid 1990s there have been protracted periods of Japanese price deflation. In January 2013 Japan introduced a 2 per cent CPI inflation target. This was accompanied by a massive expansion of its quantitative easing programme, principally through purchases of government bonds from investors. Following the monetary loosening, buoyed too by a loosening of fiscal policy, the rate of inflation rose. It reached 3.7 per cent in May 2014.
However, through 2015 the rate of inflation began to fall sharply, partly the result of falling commodity prices, especially oil. Now there appears to be an increasing fear at the Bank of Japan that deflation may be set to return. The introduction of a negative deposit rate is intended to prevent deflation. In particular by affecting expectations of inflation. The hope is to prevent a deflationary mindset becoming re-established.
The further loosening of monetary policy through a negative interest rate follows on the heels of an acceleration of quantitative easing last October. Back then, the Bank of Japan said that it would conduct Open Market Operations so that the monetary base would increase annually be ¥80 trillion. This was reaffirmed in its 29 January announcement. For an economy that has experienced four recessionary contractions since 2008 and with provisional estimates suggesting that it contracted by 0.4 per cent in the final quarter of 2015, it remains to be seen whether further monetary loosening might yet be called for.
Data
Consumer Price Index Statistics Bureau of Japan
Articles
Bank of Japan adopts negative interest rate policy CNBC, Nyshka Chandran (29/1/16)
Japan adopts negative interest rate in surprise move BBC News (29/1/16)
Bank of Japan shocks markets by adopting negative interest rates Guardian, Justin McCurry (29/1/16)
Japan stuns markets by slashing interests rates into negative territory Telegraph, Mehreen Khan (29/1/16)
Japan introduces negative interest rate to boost economy The Herald, (29/1/16)
Questions
- What does a negative interest rate on deposits mean for depositors?
- What effect is the Bank of Japan hoping that a negative deposit rate will have on the Japanese economy? How would such effects be expected to occur?
- What effect might the Bank of Japan’s actions be expected to have on the structure of interest rates in the economy?
- How might the negative interest rate effect how people wish to hold their wealth?
- What are the dangers of deflation? Why is the Bank of Japan keen to avoid expectations of deflation becoming re-established?
- To what extent are national policy-makers able to exert pressure over the rate of inflation?
Are emerging markets about to experience a credit crunch? Slowing growth in China and other emerging market economies (EMEs) does not bode well. Nor does the prospect of rising interest rates in the USA and the resulting increase in the costs of servicing the high levels of dollar-denominated debt in many such countries.
According to the Bank for International Settlements (BIS) (see also), the stock of dollar-denominated debt in emerging market economies has doubled since 2009 and this makes them vulnerable to tighter US monetary policy.
Weaker financial market conditions combined with an increased sensitivity to US rates may heighten the risk of negative spillovers to EMEs when US policy is normalised. …
Despite low interest rates, rising debt levels have pushed debt service ratios for households and firms above their long-run averages, particularly since 2013, signalling increased risks of financial crises in EMEs.
But there is another perspective. Many emerging economies are pursuing looser monetary policy and this, combined with tighter US monetary policy, is causing their exchange rates against the dollar to depreciate, thereby increasing their export competitiveness. At the same time, more rapid growth in the USA and some EU countries, should also help to stimulate demand for their exports.
Also, in recent years there has been a large growth in trade between emerging economies – so-called ‘South–South trade’. Exports from developing countries to other developing countries has grown from 38% of developing countries’ exports in 1995 to over 52% in 2015. With technological catch-up taking place in many of these economies and with lower labour and land costs, their prospects look bright for economic growth over the longer term.
These two different perspectives are taken in the following two articles from the Telegraph. The first looks at the BIS’s analysis of growing debt and the possibility of a credit crunch. The second, while acknowledging the current weakness of many emerging economies, looks at the prospects for improving growth over the coming years.
Articles
‘Uneasy’ market calm masks debt timebomb, BIS warns The Telegraph, Szu Ping Chan (6/12/15)
Why emerging markets will rise from gloom to boom The Telegraph, Liam Halligan (5/12/15)
Questions
- How does an improving US economy impact on emerging market economies?
- Will the impact of US monetary policy on exchange rates be adverse or advantageous for emerging market economies?
- What forms does dollar-denominated debt take in emerging economies?
- Why has south–south trade grown in recent years? Is it consistent with the law of comparative advantage?
- Why is growth likely to be higher in emerging economies than in developed economies in the coming years?
The Federal Reserve chair, Janet Yellen, has been giving strong signals recently that the US central bank will probably raise interest rates at its December 16 meeting or, if not then, early in 2016. ‘Ongoing gains in the labor market’ she said, ‘coupled with my judgement that longer-term inflation expectations remain reasonably well anchored, serve to bolster my confidence in a return of inflation to 2%.’ This, as for many other central banks, is the target rate of inflation.
In anticipation of a rise in US interest rates, the dollar has been appreciating. Its (nominal) exchange rate index has risen by 24% since April 2014 (see chart below).
In the light of the sluggish eurozone economy, the ECB president, Mario Draghi, has been taking a very different stance. He has indicated that he stands ready to cut interest rates further and increase quantitative easing.
At the meeting on 3 December, the ECB did just that. It announced a further cut in the deposit rate, from –0.2 to –0.3 and an extension of the €60 billion per month QE programme from September 2016 to March 2017 (bringing the total by that time to €1.5 trillion – up from €1.1 trillion by September 2016).
Stock market investors had been expecting more, including an increase in the level of monthly asset purchases above €60 billion. Consequently stock markets fell. Both the German DAX and the French CAC 40 stock market indices fell by 3.6%. The euro also appreciated against the dollar by 2.7% on the day of the announcement. Nevertheless, since April 2014, the euro exchange rate index has fallen by 13%. Against the US dollar, the euro has depreciated by a massive 31%.
So what will be the consequences of the very different monetary policies being pursued by the Fed and the ECB? Are they simply the desirable responses to a lack of convergence of the economic performance of the US and eurozone economies? In other words, will they help to bring greater convergence between the two economies?
Or will the desirable effects of convergence be offset by other undesirable effects for the USA and the eurozone and also for the rest of the world?
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Will huge amounts of dollar-denominated debt held by many emerging economies make it harder to service these debts with an appreciating dollar? |
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How much will US exporters suffer from the dollar’s rise and what will the US authorities do about it? |
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Will currency volatility lead to currency wars and, if so, what will be their economic effects? |
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Will the time lags involved in the effects of the continuing programme of QE in the eurozone eventually lead to overheating? Already euro money supply is rising, on both narrow and broad measures. |
The following articles address these issues.
Articles
The Fed and the ECB: when monetary policy diverges The Guardian, Mohamed El-Erian (2/12/15)
European stocks slide after ECB dashes hopes of major QE expansion The Guardian, Heather Stewart and Graeme Wearden (3/12/15)
Mario Draghi riles Germany with QE overkill The Telegraph, Ambrose Evans-Pritchard (3/12/15)
How the eurozone missed its shot at a recovery The Telegraph, Peter Spence (3/12/15)
Yellen Signals Economy Nearly Ready for First Interest-Rate Hike Bloomberg, Christopher Condon (3/12/15)
Exchange rate data
Effective exchange rate indices Bank for International Settlements
Exchange rates Bank of England
Questions
- What would be the beneficial effects to the US and eurozone economies of their respective monetary policies?
- Explain the exchange rate movements that have taken place between the euro and the dollar over the past 19 months. How do these relate to the various parts of the balance of payments accounts of the two economies?
- Is it possible for the USA to halt the rise in the dollar while at the same time raising interest rates? Explain.
- Why are some members of the ECB (e.g. the German and Dutch) against expanding QE? Assess their arguments.
- What will be the impact of US and eurozone monetary policies on emerging economies?
- What will be the impact of US and eurozone monetary policies on the UK?
- Why did the euro appreciate after the Mario Draghi’s press statement on 3 December? What has happened to the dollar/euro exchange rate since and why?
In the blog Japan’s interesting monetary policy as deflation fears grow we detailed the aggressive monetary measures of Japan’s central bank to prevent a deflationary mindset becoming again established. In January it introduced a negative interest rate on some deposits placed with it by commercial banks. This is in addition to it massive quantitative easing programme to boost the country’s money supply. Despite this, the latest consumer price inflation data show inflation now running at zero per cent.
The latest inflation numbers appear give further credence to the fear of the Bank of Japan that deflation is set to return. The introduction of a negative deposit rate was the latest move to prevent deflation. As well as encouraging banks to lend, the move is intended to affect expectations of inflation. By adopting such an aggressive monetary stance the central bank is looking to prevent a deflationary mindset becoming re-established. Hence, by increasing the expectations of the inflation rate and by raising wage demands the inflation rate will rise.
of the quantitative easing programme announced in October 2015 to conduct Open Market Operations so as to increase the monetary base annually by ¥80 trillion.
