The package of quantitative easing announced today by the new regime at the Bank of Japan is one of the largest monetary injections ever announced by the central bank of a major developed economy. The only rival for that crown is the emergency easing in monetary policy which took place in most economies in late 2008. But today’s BoJ action has not been driven by any short-term emergency. It represents a deliberate change in philosophy, and a complete abandonment of everything that the Bank of Japan has said about monetary policy in the past two decades. Those who believe in quantitative easing certainly have their experiment, writ large in Tokyo.
In effect the new governor, Haruhiko Kuroda, has imported into Japan the whole of the Federal Reserve’s post-Lehman balance sheet strategy, and he will implement it in under two years, instead of the five years or more taken by the Fed. The doubling in the Japanese monetary base over a period of 21 months is in itself remarkable. Taken together with the extension of the duration of bonds purchased from less than 3 years to an average of 7 years, the injection becomes of historic proportions.
The new strategy brings, for the first time, a real prospect of breaking the deflationary psyche which has plagued Japan for so long. But it also brings risks that the strategy might work too well, with inflation expectations unhinging the bond market. Mr Kuroda is trying to pull off a difficult trick, which is “to drastically change the expectations of markets and economic entities”, and to do so in a very particular way.
The intended impact on equity prices and the exchange rate is obvious. So too is the desired increase in inflation expectations across the whole economy, an increase which would reduce real interest rates and increase wage settlements. More problematically, all of this is intended to occur while holding bond yields down, even as inflation expectations rise.
The purchases of long duration bonds by the central bank will be so large that this is a conceivable outcome, and indeed this combination has occurred, so far, in the US, capping bond yields in the process. Any significant rise in the JGB yield would, however, be the canary in the coal mine, telling us that the strategy is failing.
It is important to be clear exactly what Mr Kuroda thinks he is doing, and what he does not think he is doing. This is not helicopter money, because the rise in JGB holdings (although large enough to finance more than the entire budget deficit in the next two years) is intended to be reversed in the long run. The strategy is firmly intended to be in the realm of monetary policy, not fiscal policy. Nor is it overt exchange rate manipulation, SNB-style. Having flirted briefly with a policy of deliberately buying foreign bonds, the BoJ and the government have not pressed this button.
Instead, this is intended to be an outsize dose of internal balance sheet manipulation between the central bank and the Japanese financial sector. This follows the Bernanke code to the letter, probably including a belief that any further reduction in the exchange rate would be an ancillary benefit which should not be seen as a beggar-thy-neighbour attack on other countries.
As Mr Bernanke has said repeatedly in the US context, all countries will benefit from a healthy Japanese recovery. But of course, these lines are hard to draw, and there will be consternation in many of Japan’s Asian trading partners, who may now be forced by rising exchange rates to follow the BoJ, however reluctantly.
So if this is a large dose of unconventional, domestic monetary easing, exactly how large is the dose? The simplest way of measuring this is to compare the likely rise in the BoJ balance sheet with the rise in the Fed balance sheet over the past 5 years:
The BoJ balance sheet, as a percentage of GDP, was larger than the Fed’s when the financial crisis struck, but the Fed closed the gap in 2008-11. Making the assumption that the Fed continues QE3 at its present pace throughout 2013, and at half that pace up to mid-2014 (stopping thereafter), the total rise in the Fed’s balance sheet from mid 2008 to end 2014 will be about 17 per cent of GDP. Before today, the BoJ equivalent was intended to be about 21 per cent of GDP. Now it is intended to be almost 40 per cent of GDP. The remarkable acceleration in 2013-14 takes the BoJ programme to about twice the monthly scale of the Fed’s QE3 programme. The resulting rise in the monetary base is what Mr Kuroda calls “quantitative easing”.
These balance sheet figures, however, fail to take into account that the Fed has been buying much longer-dated debt than the BoJ up to now. Therefore the Fed’s policy has been taking much more bond duration out of the hands of the private sector, and the impact on the economy via the portfolio-balance route (forcing private investors to replace the bond duration risk with other forms of equity and credit risk) has been much larger in the US than in Japan.
Up to now, the BoJ has mostly focused its QE policy on short dated bonds, in the hope that a rise in the monetary base would eventually leak out of the banks into the rest of the economy. This has never happened, so today they have adopted the Fed’s portfolio-balance approach, greatly extending the duration of the bonds they will remove from the market. In Mr Kuroda’s language, this is “qualitative easing”.
The impact of adjusting the central bank’s bond holdings for duration is shown in the second graph (calculated by my colleague Ziad Daoud). This adjusts all of the central bank’s bond holdings, which vary from 3 months to 30 years in duration, to the equivalent risk which it would have held if it had only bought 10 year bonds:
On this basis, which is probably preferable to the simple balance sheet approach, the change in BoJ policy is even more dramatic. Having fallen a long way behind the Fed in the past 5 years, today’s programme will more than close the gap before the end of 2014. On a duration-adjusted basis, the BoJ will acquire bonds equivalent to about 15 per cent of GDP over two years, while the Fed will acquire only about one-third of that amount.
We are about to discover whether domestic monetary policy, working alone, can overcome a deflationary trap. In sharp contrast to all previous efforts by the BoJ, the Kuroda strategy will not fail for lack of scale. Although inherently risky, it has a reasonable chance of success, via its impact on financial markets, and on inflation expectations. Those are the places to look for early indicators of whether this unprecedented monetary “big bang” is succeeding, or going badly off course.