"There is something you should know about me, about inception. An idea is alike a virus, resilient. Highly contagious. The smallest seed of an idea can grow. It can further define or destroy you." - Leonardo DiCaprio's character Cobb in "Inception"
On June 13, 2013, Sayuri Shirai, Member of the Policy Board for the Bank of Japan (BoJ), delivered an extensive speech to business leaders in Asahikawa on monetary policy titled "Japan's Economic Activity, Prices, and Monetary Policy: Monetary Policy in the Past and Present." For me, this speech was very revealing, informative and enlightening. I was particularly intrigued by Shirai's discussion of what is essentially the psychological aspect of implementing monetary policy, where inflation expectations clash with the incentives for saving versus investing versus consuming. Shirai makes it clear this psychology forms the foundation of an anti-deflationary monetary policy.
Shirai describes four main aspects of the aggressive monetary policy called Quantitative and Qualitative Monetary Easing (QQE):
- Increase in Purchases of Japanese Government Bonds (JGBS) and Extension of Their Maturities
- Increase in Purchases of Risk Assets
- Emphasis on Inflation Expectations and Adopting the "Quantity" Target
- Effective Communication Strategies
I will focus on Aspects #3 and #4.
For Aspect #3 (emphasis mine):
"…QQE emphasizes the expectations of markets, firms and households - particularly medium- to long-term inflation expectations - as one of the most important channels for achieving the 2 percent (inflation) target. This feature draws a clear line between QQE and the previous CME (Comprehensive Monetary Easing). If firms and households expect inflation to rise in the medium to long term, that may positively affect the current levels of sales prices and wages. Moreover, as long as the pace of increase in inflation expectations exceeds that in long-term nominal interest rates, long-term interest rates in real terms will decline and thus support an accommodative monetary environment."
Shirai implies that the failure to win the deflationary hearts and minds of Japanese citizens doomed the previous attempts at extreme monetary easing. The previous acceptance of deflation seems to show in a January 2011 Bloomberg article titled "Japan Learns to Live with Deflation." Amidst numerous examples of how Japanese consumers were benefiting from and accommodating ever lower prices, author Aki Ito cites a Bank of Japan survey that claimed "four out of five Japanese say higher costs would be 'unfavorable.'" In another survey, the Japanese government reported that "the proportion of people content with their standard of living was 63.9 percent last year (2010), compared with 63.1 percent in 1989." But Ito at the end of the article acknowledges what worries Shirai about deflation; from Shirai's speech:
"…in the context of Japan, deflation may lead to excessive appreciation of the yen, sluggish asset prices, and shortages in tax revenues - thus, a deteriorating fiscal balance results."
Shirai noted how expectations alone can help turn around financial markets:
"Expectations of stronger monetary easing since the end of 2012 have already favorably affected some markets, including the exchange rate, stock, and J-REIT markets. Firms and households have a more positive outlook for the economy."
This impact is echoed by Scott Sumner in an interview on EconTalk on "Money, Business Cycles, and Monetary Policy" on March 25, 2013, weeks before the Bank of Japan got serious about extremely aggressive inflation targeting with QQE. Sumner talks about the powerful impact of jawboning by high-level government officials:
"So even in this worst case of Japan, where you have a dysfunctional central bank that's not cooperating, isn't doing the right things to create credibility, what they've been able to do is, in 3 months, depreciate the yen dramatically - and we've seen the market respond to specific announcements coming out of the government on monetary policy. So, we know they are linked. Speeches by the new Prime Minister, and so on. Stock market's up, what, 45% in the last 3 months. Phenomenal increase. And again, the stock prices have been strongly linked to various public statements from the Administration there proposing a higher target of 2%. First, as you know, they've had mild deflation in recent years. So, here's a case of a central bank doing far less than I would ask them to do, in a situation where I would even be doubtful if it would have any credibility, given how little enthusiasm they have for this. And yet the markets seem to have treated it very seriously, and actual exchange rates and stock prices and other variables have moved very strongly in just a hope that they'll do what the government wants them to do. There's no promise out of the central bank they are actually going to hit a 2% inflation target."
The market's ability to anticipate is also its ability to fully price, even overshoot, imminent events. The Bank of Japan's new QQE is barely two months old, yet the Japanese yen (FXY) has already reversed almost all its losses against the U.S. dollar (in my opinion, a great spot to start building fresh short positions versus the yen). The headline explanations are that the market is disappointed the Bank of Japan is not already doing more…this time to curb the volatility in the bond markets. Of course, the Bank of Japan itself is primarily responsible for the volatility as it succeeds in pushing the bond market to believe in future inflation while at the same time working against the market's pricing mechanism by buying bonds to keep rates low.
A roundtrip for the Japanese yen
The volatility threatens to derail the Bank of Japans plans. Stability is a goal Shirai made clear when describing the Bank of Japan's opportunity to fight deflation with the gas pedal to the floor:
"In this favorable environment, I believe that it may be possible to accelerate the pace of rise in medium- to long-term inflation expectations in a stable manner by adopting a bold monetary policy. At the same time, I honestly feel that the Bank should maximize its monetary easing measures to demonstrate its strong determination to conquer deflation."
"Maximizing the opportunity" means speaking and acting in bold terms. To raise expectations, the Bank of Japan changed its focus for money market operations from interest rates (also called the uncollateralized overnight call rate) to the quantity of money in the economy, also known as the monetary base. The BoJ was very deliberate and very clever in making this change. The change in tools works more directly on the general population rather than just the financial wonks who talk monetary policy every day (emphasis mine):
"There are several reasons for adopting the monetary base, which comprises cash (banknotes and coins in circulation) and reserve deposits (financial institutions' current account deposits with the Bank). Using the monetary base, it is intuitively easier for the public and market participants to grasp the essence of monetary easing: an increase in the "quantity" can easily be connected to a large-scale supply of cash, thereby creating an image of inflation. In addition, the monetary base is often used in financial markets as a reference for measuring the scale of monetary easing across central banks. Moreover, the monetary base is a basic concept presented in macroeconomic textbooks, and so it is globally known. Finally, changing the main operating target effectively signals a change in the monetary policy framework."
The BoJ made it easier to understand and accept that its policy will create inflation. Notice the desire to create an image, not just a concept. It is monetary inception, mind over yen. In the U.S., inflation worryworts like myself readily leverage the language of money-printing to describe the scourges of inflation and the need to hedge against debasement with gold. The Bank of Japan wants to tap into that ethos by making it clear it too is "printing" just like other central banks with accomodative policy. I will cover this notion of money-printing in a future post - U.S. Federal Reserve Chair Ben Bernanke has long explained that the Fed's QE is not money-printing, but he quickly gave up fighting against the common vernacular.
The end result is dramatic. The Bank of Japan "…decided that the monetary base should rise at an annual pace of about 60-70 trillion yen over two years - this would double the amount outstanding from 138 trillion yen at end-2012 to about 200 trillion yen at end-2013 and further to 270 trillion yen at end-2014….The last figure would account for nearly 60 percent of nominal GDP - far above the levels of other advanced economies." So if someone insists on believing Japan will remain stuck in deflationary conditions, that person may need to believe in worldwide deflation.
In Aspect #4, the BoJ hones its message by fixing the number two, the inflation target, in peoples' minds. It may sound silly or even superstitious but the power of suggestion often does:
"The fourth characteristic of QQE is that the Bank uses the number 'two' a great deal: 2 percent price stability target; a time horizon of about two years; doubling the monetary base and the amounts outstanding of JGBs and ETFs; and doubling the average remaining maturity of JGB purchases. The Bank does so to send a clear message about the new framework and its strong determination to achieve the 2 percent target. Indeed, positive reactions have been received both domestically and abroad regarding the clarity of the new communication strategy."
Shirai explains how previous attempts at inflation targeting were too "passive" and not convincing enough. Under CME, the total amount of asset purchases was large but the piecemeal approach of raising the amount nine times made policy appear passive and ineffective. The BoJ appeared tentative and reluctant. Now, with a concerted effort to go after the hearts and minds of the Japanese with mind over yen, Shirai can confidently proclaim:
"I regard the adoption of the 2 percent target as a major achievement in the history of the Bank's conduct of monetary policy."
Be careful out there!
Additional disclosure: In forex, I am net short yen.