Inflation targets and QE - lessons from Japan

The Japanese economy has been struggling for a while, since before the Global Financial Crisis. The problem has been a period of prolonged recession and deflation and virtually all policy attempts have failed to correct the situation.

Exports are now falling, previously one of the few bright areas for Japan, and now a serious situation faces the country.

One problem is that the Japanese people just don't want to spend and domestic demand is weak. This is encouraged by the falling price level (deflation), why should you buy goods today when in a few months they will be cheaper? The mentality of the population needs to be changed to help boost Aggregate Demand.

What does not work is lowering interest rates, they have tried that and actually had years of negative real interest rates. There have also been fiscal stimulus packages that have seen tax cuts and more government spending,  things would have been even worse had they not done this but the problems continue. So what can they do?

One suggestion is that the Bank of Japan raise its inflation target from 1% to 2%. One reason why the Bank of England has a target of 2% is to prevent any chance of a slide into deflation. This seems sensible, but all a bit late now.

The next alternative is massive Quantitative Easing (QE). Print Yen and pump them into the economy. Here they will rely on households and firms having very high money balances as a result and so they will want to spend the cash to re-balance their portfolios. (The resulting fall in yields - already very low - has already failed to work).

Of course Japan also requires Europe to sort itself out so they can start buying Japanese exports again. But when you here people telling you that QE has gone too far and will be inflationary you must point of that this is exactly what is needed - higher demand and stable inflation - not deflation.

The BBC report Japan's woes here

Just because it has not changed does not mean its not significant

Today both the European Central Bank (ECB) and Bank of England decided to leave interest rates unchanged. For the UK it means interest rates have been at an all time low of 0.5% since March 2009.

This lack of change is deceptive. The low interest rates reflect concerns over the very low levels of demand in the economy and the expansionary monetary policy which is trying to stimulate Aggregate Demand. So what is happening is an ongoing active monetary policy.

But rates are pretty much as low as they can go (although there are rumours of a fall to 0.25% next month) and additional help through more Quantitative Easing (printing money) may still be required to help the economy recover.

The decisions to be made about monetary policy are not straightforward. The Bank of England must predict what inflation will be in two years time. As the linked article below shows it is not even clear what the July to September GDP figures will be, so predicting influences on inflation up to two years ahead is far from straightforward.

Monetary policy is a key policy weapon. Balancing the needs of growth (which needs low interest rates) and inflation, which is still above target, is a continuing headache.

The BBC explain some of the difficulties here

Does this mean QE has failed?

Today it has been reported that the high street banks are raising their mortgage rates by between 0.25% and 0.5%. This is despite the fact that the Bank of England is unlikely to raise rates for at least the rest of the year and there has been more Quantitative Easing.

The problem for the economy is that higher rates of interest, especially for mortgages, will lead to lower discretionary income and so lower aggregate demand. This is exactly the opposite of what the economy needs at present.

The aim of Quantitative Easing is to increase the liquidity in the money markets and so reduce the market rate of interest. Yet the high street banks say that they are finding it more expensive to obtain funds and hence the rise in mortgage rates.

The problem for the banks is that they have to pay somebody for the use of the funds they lend to customers. This may be those who save with them or they may borrow in the interbank market.

Karl Popper, a philosopher of science, urged theorists to set out falsification conditions for their ideas.  These are things that would be observed if the theory is wrong. It would seem that after three rounds of QE and the ECB lending billions to UK banks, the rise in market rates qualify as a falsification condition for the effectiveness of monetary policy.

The Independent covers the mortgage rate rise here

The Telegraph covers British banks borrowing from the European Central Bank here

Written from my sick bed

New round of stimulus by Bank

The Bank of England is injecting another £50bn into the economy. They say that while many indicators are looking up there are too many uncertainties and the Euro area, Britain's main export market is at best flat.

The aim is to put extra liquidity into the financial markets, push yields (interest rates) down and this will lead to increased demand through higher consumption and investment in the economy and the recovery will be given a boost.

This new round of quantitative easing, which is being called QE3, is drawing both good and bad comments. Some feel that the good January figures for the UK economy are merely a blip and won't be sustained and the others that the 'headwinds' faced with the economy are still strong and so this is a welcome move.

Others say that this is an inflation risk and that the effect on yields is going to seriously affect savers and especially people retiring this year and in the next few years.

All policy is a trade-off and so there are always costs. A more important question is will it work? Monetary policy is a notoriously blunt instrument and has long and variable lags. There are good reasons to think that QE3 is like 'pushing a piece of string', there is no effect at the other end of the process.

The Independent covers QE3 here

What to do with Monetary Policy?

This week the Monetary Policy Committee will hold their monthly meeting. Interest rates will stay at 0.5%, that's a given, but further Quantitative Easing is a possibility.

Today there is an opinion piece in The Guardian on what they could do. The piece looks at the cost of the recession, the size of the stimulus package so far and the consequences of the end and reverse of Quantitative Easing.

This article shows just how difficult the decision process is, with various competing factors to consider. Among other points raised is the effect of reversing Quantitative Easing. The government debt that the Bank of England have bought up in the market to boost the money supply will need to be sold. Doing this will push bond prices down and so interest rates up, possibly affecting the pace of the recovery post 2015.

This is an article that should be read to the end, but remember it is an opinion piece, not news and you should remember the writers bias.

The Guardian article is here

Monetary boost to avoid inflation being too low

The Bank of England Monetary Policy Committee kept interest rates on hold today. No surprise there, nor in the announcement that that there would be more quantitative easing (QE).

The aim of the MPC is to keep inflation at 2% on the CPI measure. But they can't work in the short term, inflation is a complicated process and monetary policy takes up to two years to take effect, so the MPC must aim to keep inflation on target in two years time.

At the moment inflation is well above target and will go up rather than down in the next few months. So why not try to contain inflation? Well the horse is several fields away on that one and so the MPC look past he current inflation figures as they cannot affect them. They see the VAT rise dropping out of the index in January, weak economic growth around the world reducing export growth and domestic inflationary pressures being contained. They believe that without action inflation will drop below 2% in the final quarter of 2013.

So the MPC will boost the liquidity of the financial sector by pumping £75bn of new money into the economy. This will stimulate lending and demand and hopefully assist growth in aggregate demand.

The BBC have helpfully restored their Q&A on Quantitative Easing, explaining how it works, why it is used and why its not going to cause runaway inflation such as the German and Zimbabwe hyper-inflations. The BBC Q&A will answer the questions of Deps on what this measure means, but everyone should read the reports of this move carefully.

The BBC Q&A on QE is here