Abenomics, Deflation and the Japan Conundrum Revisited

by George Hatjoullis

On March 27, 2013, I published a blog post entitled Abeconomics, deflation and the Japan conundrum. The thrust of this blog was that the QE would not achieve Abe’s inflation promises and Japan would need to resort to monetary financing if it was to succeed. Today the Bank of Japan pushed back its inflation forecasts, yet again, but monetary financing is not on the agenda. It is ironic that monetary financing is taboo because of its inflation potential. I have, since the publication of the original blog, published many others explaining how monetary financing works and how it can be used safely. A brief recap.

In its simplest form monetary financing is the central bank printing money and giving it to the state to spend, no questions asked. The precise institutional details of how this is achieved is a distraction. If the economy is operating below potential this will merely lead to more output and employment. GDP will grow with little impact on inflation until the economy approaches potential. At this juncture the CB should cease monetary financing. It is a shot of adrenaline to get the heart pumping. If the central bank is truly independent and the mandate is price stability, then there is little policy risk in this arrangement. There is of course measurement risk. Monetary financing should not be viewed as a normal policy tool. It should only be used in extreme circumstances when the economy seems stuck below potential and where generating inflation seems to be a problem. Japan clearly exhibits these symptoms. Increasingly so does the rest of the world.

This may sound too simple to be true. First, note potential is defined as the point at which inflation accelerates. The only way to be sure the economy is at potential is to observe inflation. The GDP price deflator is the relevant index in this respect. The performance of GDP price deflators suggests the global economy is operating well below potential. Second, note inflation is an average. There will be some sectors booming, whilst others are in decline. This is not however a concern of macro economic policy. The latter deals with aggregates. You should be suspicious of the tendency to disaggregate such aggregate measures to indicate a different condition. So called ‘core’ inflation is often emphasised. The definition of ‘core’ however is simply to exclude food and energy ( I have devoted a whole blog to explaining the theoretical origin of the core concept and it is rooted in wages and productivity, not food and energy). Given how big a proportion of household budgets food and energy constitute, this makes no sense. Third, extra spending may lead to more spending on imports and a trade deficit. Indeed it might. In a freely floating exchange rate regime this may lead to currency depreciation and this will contribute to the inflationary stimulus. This is the precisely what is needed.

A short burst of monetary financing is worth a shot in the present global economic condition. It can be achieved simply through debt cancellation by the CB. It writes off government debt bought during the various Quantitative Easing programmes. If it is carefully calculated and limited it would indeed be a shot of adrenaline. The risk lies in normalisation of such an action as a policy tool. This should never be allowed. The problem however is that even this may not work. Once again Japan, but increasingly the US and UK, provides an illustration.

Unemployment in Japan is 3.4%. At this sort of level one might reasonably expect wages to be rising and thus putting upward pressure on general prices. Not so far it seems. It may be Japan is about to experience an abrupt jump in wage growth and inflation. Then again it may not. The issue rather begs the question of why wage growth has remained muted as unemployment levels have declined. This is evident in other economies as well. One can speculate about the answer but it is just that; speculation. In Japan, the UK and the US, focus should not be on inflation measures or monetary policy. It should be on the behaviour of wages. Inflation may not pick up to target levels until nominal wage growth accelerates.