Japan and the Inflation Outlook

by George Hatjoullis

The headline in the FT this morning is ‘ Bank of Japan downgrades GDP and inflation forecasts‘. Abeconomics or Abenomics dates back to December 2012. The brave claim was that the BoJ would increase the inflation rate to 2% in two years by doubling the money supply. I think we can safely say this is not going to happen. On March 27, 2013, I published my first blog on the subject of Japan and Inflation, Abeconomics,deflation and the Japan conundrum in which I suggested that the Bank of Japan would eventually need to resort to debt cancellation or, what amounts to the same thing, monetary financing. The need to reintroduce monetary financing as a policy option has been a constant theme of my blogs, especially in the light of the fact that fiscal orthodoxy has eliminated fiscal policy as a tool for aggregate demand management. I have explained how monetary financing might work, the risks and the restrictions necessary to avoid abuse. Most important, I have tried to show that it will prove necessary, first in Japan, and then more widely. Japan has arrived at the point when it should seriously consider this option.

My efforts to highlight this issue have not been restricted to my blogs. The FT has published two of my letters on the subject, Taboo on printing money is an anachronism and Only option left is debt cancellation. The idea is not, obviously, uniquely my own. Other voices are suggesting the same thing. However, it is a minority view and one that is regarded as not to be taken seriously. It is a testament to the intellectual impotence of economics that potentially useful tools are ignored simply because they can be, and were once, abused. As always in human history the tool will be rediscovered after calamity has befallen us.

One reason for the failure to consider this tool (apart from past abuse) is the asymmetric view of inflation. Central banks fear inflation more than deflation. They should not. They also believe that economies have a predisposition to inflation and left alone they will drift higher. Central banks, it is believed, need not do much if inflation is low. In fact they need to be ever vigilant and be prepared to pull interest rate trigger (higher) if the inflation dragon rears its ugly head. So another headline in this mornings FT is UK central bank governor says rate rise is near despite no inflation. A queue of Federal Reserve governors have announced interest rate rises are coming even though there is no present inflation emergency. The logic is that monetary policy acts with a lag and inflation will pick up because, well, because it always does. The interest rate increases will come because central bankers seem convinced that they should despite no obvious evidence to support this as yet. It is an act of faith.

My own view is that there is a policy error in the making. I have tried to articulate my reasons in successive blogs but the ideas are too off the wall even for economists to grasp and most of my audience is of laypeople. My central view is that the 2008 banking crisis destroyed money. A bank deposit has always been viewed as money but is not. It is a loan to the bank. Money is a liability of the central bank. You do not have an account with the central bank. The only true money for the person in the street is cash. The next best thing is national savings (guaranteed by the government) and insured deposits (funded by the banking industry but ultimately underwritten by the government). The insurance limit in the UK is presently £85k but is about to fall to £75k (did you know this?). Uninsured deposits are loans to the bank that are in principle available to recapitalize the bank if it fails. You may regard this as unimportant. If is unimportant why has the Bank of England introduced special provision to protect or insure temporary deposits of up to £1m arising from discrete events such as house sale? The quality of bank money has changed dramatically since 2008. Much of it is not money. If the stock of money diminishes just as demand increases, as happened after 2008, then there is a period of excess demand for money. The result is a deflationary bias.

The central banks have been busy offsetting this through quantitative easing. Or so they think. They have removed risk free government debt from the system and replaced it with bank deposits! If the problem is the quality of bank deposits this can hardly have helped. So the so-called money printing (QE is NOT money printing) has potentially made matters worse. The evidence at the moment favours my interpretation. Where is the inflation after years of aggressive QE? However, this evidence is ignored at each meeting( see for example BoE). Whether in the US, UK or Japan, the same optimistic projections are produced at each meeting, ignoring the fact that the last set of forecasts missed. Well, not in Japan, any longer. The BoJ has downgraded it forecast. This is an important warning. What will they do if deflation returns?