The experimental-drug phase of monetary policy has begun. The usually-cautious Japan is leading the way with a policy of quantitative easing, hoping to boost exports and steer its economy away from deflation. But Japan's problems are not unique; in the wake of the financial crisis, economies worldwide are facing a global shortage of demand and competing for their share of exports. The United States has moved decisively toward quantitative easing, with the Federal Reserve hinting at further steps by early November. This prospect, and the sharp drop in the dollar it has caused, will force more quantitative easing in Asia and Europe if countries there wish to avoid further deflationary currency appreciation.
Key points in this Outlook:
- Facing a strong yen and slow global growth, Japan began a round of quantitative easing on September 15 to combat the threat of deflation.
- To succeed with quantitative easing, Japan must set a price-level target that coincides with zero to 1 percent inflation and reverse its easing policy once that target is reached.
- Facing a global shortage of demand, the United States and other leading economies will follow Japan's lead and implement quantitative easing to fight deflation.
It is fitting that on September 15 Japan, the world's only major economy battling actual deflation, initiated what has come to be a global round of quantitative easing. Quantitative easing involves a central bank creating money to buy securities, adding reserves to the banking system, and hoping to increase lending and economic activity in the process. The Bank of Japan's last round of easing lasted five years. The current easing process will last a while as well, in part because while Japan is experiencing actual deflation, other Asian countries--and some emerging-market economies such as Brazil--appear to fear deflationary pressures as well. These countries are buying dollars to resist the deflationary impulse being exported from the United States, as signals of further accommodative policy from the Federal Reserve continue to weaken the dollar.
The Federal Open Market Committee, in a statement on September 21 designed to highlight its rising concern about inflation falling too close to zero--that is, to the cusp of deflation--reported the following: "Measures of underlying [core] inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." The Fed's signal to initiate more quantitative easing, in the form of purchases of long-term Treasuries, if core Consumer Price Index inflation (now at a 0.9 percent year-over-year rate) continues to drift lower, means that the dollar weakness that translates into the export of U.S. deflationary pressure will persist. This will force Asian central banks resisting deflationary currency depreciation to continue to follow Japan's lead and intervene even more aggressively to buy dollars. Almost no country wants--or can afford--a stronger currency in a world of shrinking demand. After the Fed's announcement of its intention to combat further U.S. disinflation, the trade-weighted dollar slipped to its lowest level since March.
A notable exception among Asian countries is China, which has chosen to allow some currency appreciation to help cool its overheating inflation pressure. For China, there is no conflict between its own desire to control inflation (and inflation expectations) and allowing its currency to strengthen. An additional bonus is the attendant reduction of trade tension with a grumpy U.S. Congress and other Asian countries, such as Taiwan, South Korea, and Japan, that have excess capacity in the traded-goods sector and are struggling to compete with China's robust exporters.
Japan's New Quantitative Easing
Exactly what did the Japanese government do on September 15? The Japanese Ministry of Finance directed a reluctant Bank of Japan to buy dollars in large quantities to arrest the deflationary appreciation of the yen that was underway. This amounted to a second round of quantitative easing because the proceeds of the dollar purchases by the Bank of Japan from banks and companies inside Japan were left in the financial system and not "sterilized"--that is, offset by sales of government securities, as has almost always been the case with Japan's previous interventions. Instead, the Bank of Japan printed the money to finance these purchases. Japan wanted the $23 billion worth of dollar purchases (with more to come) to spill into purchases of domestic goods and services, and perhaps into purchases of domestic and foreign bonds.
The initial impact of Japan's intervention was positive given its reflationary objective. There was an immediate 3 percent drop in the yen's value versus the dollar, from just below 83 yen per dollar to about 85.5 yen per dollar. Japan's stock market rose by about 4 percent as shares of exports rose. These responses, given the size of the intervention, are modest. More unsterilized intervention will be needed for Japan to make significant progress in its battle against accelerating deflation. In a world of static-to-falling demand with excess capacity in the traded-goods sector, it remains to be seen how tolerant other nations will be of Japan's effort to capture, for its own output, a bigger share of the world's paltry demand growth. All that said, Japan moved first simply because it was closest to a debilitating deflationary spiral.
Since May, and prior to the currency intervention, Japan's currency strengthened by about 11 percent against the dollar--not to mention against the Chinese yuan--while strengthening 13 percent on a trade-weighted basis over the same period. A combination of a slowing global economy and a stronger currency has created a nearly impossible situation for Japan's exporters. Japan's second-quarter growth slowed sharply and unexpectedly as exports languished and domestic demand remained weak. The contrast between Japan's paltry second-quarter growth, flattered by deflation in real terms, and Germany's export-enhanced strong second-quarter growth--the result of the euro weakening in the face of southern Europe's rising debt crisis--underscored the benefits for exporting nations of a weaker currency.
Japan's chronically strong yen is symptomatic of the problems facing its economy in an environment of weakening global growth. It is important to remember that the stronger yen is not aberrant, as Japan's government has sometimes claimed, but rather is indicative of Japan's underlying deflation problem. Slower global growth exacerbates Japan's excess capacity, especially in the traded-goods sector. As a result, deflation persists or intensifies. Additional deflation strengthens the yen in two ways. First, it raises the real return on assets in Japan and therefore attracts funds either from foreign investment or through repatriation by domestic investors. The repatriation by domestic investors is intensified by the fact that the stronger yen means losses on their foreign investments denominated in foreign currencies. So, in response to the stronger yen, more foreign investment is repatriated, thereby adding further to yen strength and Japan's deflationary pressure.
In short, Japan is in somewhat of a currency-based liquidity trap, the underlying determinants of which suggest that without some exogenous shock designed to weaken or at least stabilize the yen, the deflationary appreciation of Japan's currency will continue. In this troublesome environment, Japan's new Democratic Party of Japan government and the Ministry of Finance have been at odds with the Bank of Japan. The government has been advocating aggressive measures to stabilize and weaken the yen, whereas the Bank of Japan apparently has wished to be more cautious. The Bank of Japan is reluctant to undertake quantitative easing that could be interpreted as an endorsement of the heavy borrowing required by Japan's government to finance its large deficits.
The tension surrounding the run-up to Japan's decisive quantitative easing on September 15 is reminiscent of the tension on the Federal Open Market Committee as the U.S. economy slows and the Fed contemplates its own second round of quantitative easing. But the proximate trigger for Japan's aggressive move into another round of quantitative easing came from outside the Bank of Japan when, on September 14, Prime Minister Naoto Kan was victorious in a leadership contest in Japan's ruling Democratic Party of Japan. Within twenty-four hours of his victory, Kan had directed the Ministry of Finance to instruct the Bank of Japan to undertake the quantitative-easing measures.
This decisive move was probably triggered by external considerations as well. With U.S. growth having slipped to an expected 1 to 1.5 percent annual pace in the current quarter and with the prospect of even weaker growth during the fourth quarter, Chairman Ben Bernanke has signaled that the Fed will undertake its own second round of quantitative easing probably sometime between mid-September and early November. Most observers reckon that the Fed would need to purchase up to another trillion dollars worth of Treasury securities to underscore its determination to boost the economy. With the prospect of such a liquidity surge from the United States, the Japanese government chose to initiate quantitative easing rather than face a substantially stronger yen and exacerbated deflation.
The Way Forward for Japan
As with most policy impasses, the Bank of Japan's concern about providing license for unlimited financing of the government's rising debt is understandable. However, the overriding reality is that, absent aggressive quantitative easing, Japan's damaging deflation would have only intensified. The Bank of Japan needs to ensure that the effort is successful. It should set a price-level target that implies a modest, positive inflation rate between zero and 1 percent--substantially above the current deflation rate of about 1 percent. The Bank of Japan should announce its intention to continue to undertake aggressive, unsterilized purchases of foreign exchange until the drift toward deflation is arrested. Such measures are not new and have frequently been proposed as emergency deflation-fighting strategies at international forums such as the Federal Reserve's annual Jackson Hole Symposium.
The other reason for the Bank of Japan's resistance to pursue aggressive quantitative easing is the fear of runaway inflation that might result from rapid money creation. Setting the price-level target is important because it preordains a tightening or reversal of easing policies from the Bank of Japan as soon as the price level rises above a path consistent with the modest 1 percent inflation target. By undertaking this round of quantitative easing, the Bank of Japan is not guaranteeing unlimited purchases of foreign currency or Japanese government bonds, but only an amount sufficient to weaken the yen and thereby cap Japan's damaging, self-reinforcing path to further deflation.
The Global Shortage of Demand
Japan's deflation problem, while fairly acute, is symptomatic of a typical post-financial-crisis problem. The huge erasure of wealth brought on by a collapse in the U.S. housing market has weakened private-spending growth in the United States. For the end of the second quarter, substantial growth of federal government spending and transfers cushioned the weakness in U.S. demand growth, but that fiscal thrust has turned to fiscal drag since midyear. Another source of substantial fiscal drag comes from the sovereign-debt crisis in Europe, where pledges for drastically contractionary policy by southern-European governments have further subtracted from global demand growth, notwithstanding the spotty record of achievement on such tightening to date. Meanwhile, emerging markets, where households did not suffer wealth losses in the financial crisis, have been tightening monetary policy to preempt inflation. The largest among them, China, has backed away from its own aggressive stimulus measures, bringing growth down closer to an 8 percent annual rate and thereby employing still positive, but less-intense, growth of Chinese demand for global products.
A substantial part of China's stimulus administered aggressively in 2009 was intended to increase China's production capacity and thereby create a larger supply of traded goods flowing into global markets, which enhanced the disinflationary or deflationary pressure emanating from those markets. It is perhaps no accident that Japan aggressively undertook to stop the deflationary rise in the yen. China chose to signal a modest export of inflation by allowing its currency to appreciate against the dollar and thereby against the yen. Since over a third of Japan's exports are shipped to the United States and China, if Japan is successful in maintaining and enhancing the depreciation of its currency, its exporters may receive a modest boost. However, the real need is for Japan to boost domestic demand from its private sector by convincing Japanese businesses and households that prices will stop falling and begin to rise over the coming year. Notwithstanding the high level of political tension around trade balances, Japan must realize that the major goal of this round of easing should be to arrest deflation and thereby enhance the growth of domestic demand.
Currency intervention, especially in a global economy where deflationary pressure is rising and growth is weak, is a highly political matter. While a weaker currency provides a nation with a larger share of a shrinking export pie, charges of "beggar thy neighbor" and competitive devaluation arise and echo the high level of trade tension that emerged surrounding currency moves during the Great Depression. In the current situation, acceding to Japan's overt effort to depreciate its currency undercut the U.S. effort to press China for an appreciation of the yuan aimed at redistributing global demand away from Chinese products. The Chinese have been resistant because their large stimulus program during 2009 increased the capacity in the traded-goods sector and thereby made Chinese exporters highly sensitive to a stronger yuan that weakens their competitiveness in global markets.
So far, the U.S. government has offered few specific comments about Japan's aggressive currency intervention beyond the usual grumbling in Congress. This may reflect the recognition that, in view of the substantial appreciation already experienced by the yen over the past four or five months, some effort to reverse the deflationary or contractionary impulse operating on the Japanese economy left the government with no alternative but to take preemptive steps to contain a further deflationary yen appreciation. That outcome would have spelled renewed contraction for the Japanese economy in a difficult global environment.
Although perhaps unexpected, Japan's usually passive government has kicked off a second round of quantitative easing among the world's leading economies. While the United States has not entered a deflationary period, it has been creeping steadily toward the zero-inflation barrier between rising and falling prices. On September 17, it was reported that the U.S. core inflation rate was flat in August, leaving the year-over-year measure at 0.9 percent, a reminder to the Fed that a second round of quantitative easing is needed. The September 21 Open Market Committee statement highlighted that the Fed will respond to counter further disinflation. The reservations of that committee are, as already noted, virtually identical to the reservations some members of Japan's governing board have about the new round of quantitative easing in their country. There is a significant difference though, insofar as Bernanke has been far more outspoken and less ambivalent about the need to avoid deflation with further quantitative easing if that proves necessary than has Japan's governor Masaaki Shirakawa, who is already faced with the reality of persistent deflation over the past several years and the prospect of a further acceleration to more rapid, damaging deflation.
The experimental-drug phase of monetary policy has begun, somewhat surprisingly, with the most cautious doctors--the Japanese--leading the charge. The Fed is not far behind. Both are worried about deflation: actual deflation in Japan and incipient deflation in the United States.
John H. Makin ([email protected]) is a resident scholar at AEI.