We must admit that we were quite surprised that the Bank of Japan's board, which not too long ago was run by the quite cautious Maasaki Shirakawa, would turn out to support the new "let's print till the cows come home" course of Haruhiko Kuroda unanimously. So we read with some interest at Bloomberg that "divisions emerge at the BoJ over the inflation target." It turns out that this by no means indicates that the board is divided over whether or not to pursue the inflation target, but merely over whether it can be achieved at all in the envisaged time frame. Still, the article contains a few interesting tidbits:
Bank of Japan policymakers are divided over whether the central bank can meet its inflation target in two years, underlining concerns it has set an unrealistic goal in its battle to end 15 years of deflation despite plans for a massive burst of monetary stimulus.
The central bank held off on offering any fresh policy initiatives following the April 4 policy meeting, when new Governor Haruhiko Kuroda stunned markets by promising to inject about $1.4 trillion into the economy to hit the 2 percent inflation target in roughly two years.
The BOJ's semi-annual economic report, which is based on forecasts from the BOJ board's nine members, showed the degree to which other policymakers share Kuroda's view.
Their median forecast shows they expect core consumer inflation, the central bank's preferred gauge for price trends, to reach 1.9 percent in the year to March 2016, close to the bank's target. But the forecasts of the board members ranged widely, from 0.8 percent to 2.3 percent.
And while the BOJ officially said it expected to achieve 2 percent inflation towards the latter half of its projection period out to March 2016, board members Takahide Kiuchi and Takehiro Sato dissented against that view, underlining the division in the board.
'The BOJ's inflation forecast is quite ambitious and probably pretty hard to achieve,' said Yuichi Kodama, chief economist at Meiji Yasuda Life Insurance in Tokyo. 'There's no guarantee that by expanding base money, the BOJ can heighten inflation expectations,' he said. 'It would be tough to achieve 2 percent inflation in Japan with monetary easing alone.'
A gap in the views of future inflation poses a dilemma for the BOJ because its policy relies so much on shaping market and public expectations, or trying to nudge people into spending more on the belief that prices will finally start to rise in the future.
In a reminder of the task ahead, data on Friday showed core consumer prices fell from a year earlier for the fifth straight month in March, even as the yen's recent fall pushed up import costs. Core prices, which include all items except for volatile food costs, fell 0.5 percent.
Kuroda has vowed to do whatever it takes to achieve its price target in two years, putting the central bank's reputation on the line to restore an inflation level that has rarely been hit since the early 1990s. (emphasis added)
So there are some doubts as to whether the BoJ can get prices to rise, but it sounds as though it were utterly beyond question why it should get them to do that. We have highlighted the passage above: The BoJ is "...trying to nudge people into spending more on the belief that prices will finally start to rise in the future." This example of sound Keynesian logic could also be translated as: "Let's make people poorer, then they will spend more." Right.
In the event that the BoJ should manage to get people so worried about the future value of the confetti it issues that they actually do go out and spend it as fast as possible, Japan will probably quickly reach terminal monetary velocity, so to speak. It is true that the effect additional money issuance has on prices will be uneven, can be subject to big lags, and is at least partly a question of inflation expectations. The error is in believing that any of this will be a comfortably linear affair, with the central bank pulling just the right levers to get to the point where people start spending more money, but the money doesn't end up being repudiated in short order.
We actually tend to think -- based on the interplay between BoJ and the commercial banking system to date -- that increasing base money further will initially fail to "achieve" a devaluation of the money unit that is big enough to satisfy the zeal of the new BoJ leadership. Bloomberg lets us in on what that portends:
A lack of progress in meeting the target may undermine public expectations of future price moves and force the BOJ into taking further monetary action despite unleashing the world's most intense burst of monetary stimulus earlier this month, some analysts say.
'When the BOJ updates these forecasts again, there could be speculation that it will increase debt purchases again because it won't be close to meeting its target,' said Hiroaki Muto, senior economist at Sumitomo Mitsui Asset Management Co. 'With yields already so low, this could make banks afraid to buy more government debt.' (emphasis added)
So far, the banks are not afraid to buy more government debt. The JGB market has, in spite of an increase in short-term volatility, held up remarkable well lately. Note, however, the highlighted sentence above: If rising consumer prices fail to show up, the monetary pumping will become even more pronounced.
Hitherto, commercial banks have simply reduced outstanding credit and the deposit money that went with it almost as fast as the BoJ was able to increase the money supply by means of asset purchases. Since the BoJ has been engaged in quantitative easing on numerous occasions already, something rather unusual has happened with Japan's money supply. A very large portion of it consists of covered money substitutes these days, this is to say deposit money for which cover in the form of bank reserves actually exists. Unlike other fractionally reserved banking systems, Japan's is almost fully reserved by now:
Japan's true money supply, economic categories (chart via Michael Pollaro) -- as can be seen, most of Japan's outstanding money substitutes are by now covered by standard money in the form of bank reserves.
If this trend continues, then there will soon be more bank reserves than deposits. The downtrend in domestic loans outstanding seems well entrenched:
Total loans and bills discounted of domestically licensed banks in Japan, 1990 to today (chart via Bank of Japan).
Since the banks create no new deposit money by lending to the private sector, inflating the money supply has proven difficult for the BoJ. However, that does not mean it is impossible, as it is mainly a question of its modus operandi. The markets are of two minds at the moment, as currency traders have aggressively sold the yen, while the JGB market has hardly budged:
The yen, monthly since 1989.
JGB futures, continuous weekly chart (the past five years).
In recent days, the yen has begun to bounce off the century mark against the dollar:
The yen has strengthened a little bit in the short term.
What Might Eventually Happen
It seems highly likely that import prices will increase notably as a result of the yen's weakness over the past several months. Contrast this with the fact that the money supply has increased at the pedestrian pace of 3.6% year on year, declining at an annualized pace of 23% in January. If import prices rise strongly and the money supply only increases at a very slow pace, imports will either decline or prices of other goods will come under pressure, ceteris paribus.
Assuming that the BoJ's board is aware of the slow rate of money supply growth, we can imagine that it will eventually alter its modus operandi and inject funds either directly into the economy by increasingly buying assets from non-banks (this will create both deposit money and bank reserves concurrently), or by funding government debt directly. (Then the government will inject the money into the economy by spending it; we're not sure if that is legal in Japan, but legal niceties have rarely stopped committed inflationists.) Given the high level of bank reserves, the BoJ could also opt to "mobilize" them -- i.e., give the bank an incentive to pyramid new credit atop their reserves by charging a penalty for holding them.
Lastly, it could "go Friedman" and simply drop new banknotes from helicopters. The point we want to make is this: If a central bank in a fiat money system desperately wants to inflate, it can do so. We believe one should monitor the JGB market very closely, as it is probably the market most sensitive to "success" on the inflation front. If the BoJ eventually succeeds in letting the genie out of the bottle, it may, however, find it difficult to put it back in.