What would Japan have to do to achieve a 10% inflation target?3rd June 2019
I do not expect Japan to adopt a 10% inflation target, nor do I think it’s a good idea. Nonetheless, it’s a useful thought experiment, which helps to illuminate some difficult to grasp ideas.
Let’s think about what Japanese interest rates and base money demand would look like with a 10% inflation target, assuming no IOR. Here are some plausible guesses:
1. Japanese interest rates would be roughly 10%, plus or minus 2%.
2. The Japanese monetary base would be roughly 5% to 10% of GDP.
I base the first estimate on the fact that real interest rates in Japan are currently close to zero, or perhaps slightly negative. With 10% inflation, real rates might fall slightly (due to the zero bound being lifted), or rise slightly (due to the taxation of nominal interest.) But history suggests that higher inflation expectations are mostly passed along as higher nominal interest rates.
One the second point, 5% is roughly the figure I’d expect, but given the unusually large Japanese demand for currency I put in 10% as an upper bound.
Now let’s think about where Japan is today:
1. Interest rates are roughly 0%.
2. The monetary base is roughly 100% of GDP.
Thus, to achieve a 10% inflation target the BOJ would have to raise interest rates to 10% and then cut the monetary base by 90% or 95%. After that initial cut, the base would rise by roughly 11% per year, assuming 1% trend RGDP growth and 10% inflation.
Now here is where things get confusing. Just raising interest rates to 10% and cutting the base by 90% will not magically produce 10% inflation; just as having millions of New Yorkers leave their house with umbrellas will not magically produce rain. It’s more the other way around. If you seed the clouds over New York to produce rain, then millions of New Yorkers will leave their house with umbrellas. NeoFisherian meteorologists claim that you create rain by ordering New Yorkers to carry umbrellas, citing “equilibrium conditions”. Market monetarist meteorologists claim you create rain by creating conditions where millions of New Yorkers choose to carry umbrellas.
Do you see the subtle distinction? It’s true that a non-coercive policy that indirectly causes millions of New Yorkers to choose to carry umbrellas will also cause rain, but a coercive policy of umbrella carrying will not work. Thus seeding clouds will cause rain, but having a crazy dictator say he will execute New Yorkers for not carrying umbrellas will not cause rain.
With monetary policy, you cause 10% inflation expectations with a credible policy to buy as many assets as needed to move market inflation expectations up to 10%. When is a policy credible? When the government actually intends to carry it out, whatever it takes. In that case, you probably don’t have to buy anything. Indeed just the opposite—you reduce the monetary base.
A few years ago, the Japanese government adopted a 2% inflation target, but markets correctly understood that the Japanese government had no intention of doing whatever it takes to carry out the policy. And they were right. If the Japanese government had intended to do whatever it takes, then markets would almost certainly have seen that. Markets are not stupid; they can pretty easily see whether governments are serious or not. Or if they can’t, it doesn’t take long to figure it out.
Governments are like 3-year old toddlers. They don’t have a poker face. Their emotions are clearly written in their facial expression.
To summarize, asking whether QE “works” is like asking whether umbrellas imply rain. It’s a meaningless question, unless put into some sort of context.
PS. Try this:
1. Do umbrellas keep people dry?
2. On average, are umbrella carriers wetter than those not carrying umbrellas?
I don’t know about you, but on average my pants get wetter on days that I carry an umbrella (due to wind) than on days I don’t carry an umbrella (and it’s usually not raining). So do umbrellas “work”?
QE is aimed at leading to faster NGDP growth. But, on average, countries doing QE have slower NGDP growth than countries not doing QE.
Hospitals are aimed at keeping people healthy. On average, however, people in hospitals are less healthy than people outside of hospitals.
Unfortunately, all these metaphors fall short by ignoring the role of expectations. But it’s the best I can do.
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