Putting on a brave face
19 June 2018
Japan has struggled to embrace the goldilocks scenario of solid growth, low inflation and low interest rates. Inflation remains too low, with the Bank of Japan forced into a downward revision of its assessment of core CPI to "in the range of 0.5%-1.0%" at last week's policy meeting, from "around 1%" previously. At the same time, risks associated with low interest rates are rising. Implementation costs include impaired functioning of the JGB market, financial sector profitability concerns and some signs of excesses in stock prices, real estate loans to GDP, and lending attitudes of financial institutions. There are also justifiable questions about the cost to Bank of Japan (BoJ) independence, with low borrowing costs an increasingly integral part of the government's fiscal sustainability plan; and costs of exit, with questions over policy firepower in the future in the event of a negative shock, as well as BoJ solvency. At last week's press conference, Governor Kuroda put on a brave face, appearing bullish on the inflation outlook and downplaying the side effects. However, we think the debate is set to become more fractious, with media reports regarding a BoJ review of inflation weakness pointing to growing exasperation.
One line of attack that has captured attention is the failure of policy to lead to a persistent expansion in money supply. Typically, one would expect policy designed to stimulate economic activity to prove consistent with an expansion in the money supply. Governor Kuroda's aggressive bond purchasing programme and negative interest rate policy are certainly the standard policy tools to deliver such an outcome. So why has the monetary supply been so lacklustre? It turns out that the relationship between money supply and output is a far more complicated issue. In Japan's case, money creation by the BoJ has been thwarted by a meaningful deceleration in the velocity of money, meaning that the number of times a yen is being spent on final goods and services has fallen dramatically. The most obvious explanation for this phenomenon has been the massive expansion in financial institutions' excess reserves held at the BoJ. This has reached extreme levels in recent years, peaking at an annualised rate of more than 150%, but has moderated more recently as the BoJ has sought to penalise the practice through the imposition of negative interest rates. Even at the more moderate pace of expansion, money supply growth has been modest (see Chart 8).
This has led some to conclude that Japan's problem is more structural in nature. At its most extreme, this argument suggests the rate of return on investment and companies' willingness to invest has become so low that firms are desensitised to interest rates. This is captured by Japan's so-called 'vertical IS curve'. In this environment, M2 may become completely decoupled from interest rates. What evidence is there that this has occurred in Japan? While the relationship between long-term borrowing costs and outstanding loan growth has been unusual, we think an inverse relationship is increasingly evident of late (see Chart 9). This will be welcome news for Governor Kuroda and explains why he is optimistic that the Bank's target will eventually be met. Our concern is that progress has been far too slow. Unfortunately, current policy settings are unlikely to accelerate this process, while options to ease further are constrained by rising policy costs. The opportunity may be slipping through Kuroda's fingers.