Japan’s Monetary Policy – Thoughts on Speech at BOJ by Ben Bernanke ( Part 1 )

Ben Bernanke, the former head of the Federal Reserve recently gave a talk/speech on Japanese Monetary Policy at the BOJ recently here. For those who do not know, I am a big economics nerd especially when it comes to monetary policy and I find this talk very interesting as I have also written a paper on Japanese Monetary Policy in my Academia website. The way I am approaching this would be to write down my thoughts and interpretation of what Bernanke is saying so it will seem a bit disorganised and lacking in direction. What I am hoping to achieve from this is that my readers can better understand the Japanese experience with monetary policy at the lower bound ( near zero interest rates ).

“I made the point, associated with Reifschneider and Williams (2000), that in the face of deflation risks it was important not to try to conserve policy ammunition but to move “decisively and preemptively”” (Bernanke Speech at BOJ, 2017)

I am interested in the notion of what it means by decisively and preemptively by Bernanke here. For students of economics interested in monetary policy literature, one would have come across the paper by Romer and Romer on the importance of confidence and decisiveness of central bankers to conduct monetary policy. In their conclusion, they quoted

“The approaches of two largely successful FED chairman – William McChesney and Paul Volcker suggests that the value of humility of a central banker may be overstated. Both came into office believing that monetary policy would accomplish a great deal, and both used policy aggressively.” (Romer and Romer, 2013)

Basically, it boils down to the effectiveness of central bankers and monetary policy to influence market and consumer’s expected inflation as talked about by Bernanke in the following

“Understanding the links between central bank talk and the expectations of households and businesses, and markets is an increasingly important challenge for monetary policymakers. Japan’s inflation expectations seemed overly sensitive to current developments and relatively unresponsive to central bank talk.” (Bernanke Speech at BOJ, 2017)

One of the most effective implementation of monetary policy comes during the Volcker period in the 1980s. The context of this period was that inflation was high at double digits with high oil prices (supply control by OPEC) with also recessionary environments ( low GDP growth ) coming out of the 1970s. The newly elected Volcker went on a disinflation path by explicitly saying that he will combat inflation at all cost to drive price growth down. The confidence and determination exhibited by Volcker and his team, was successful in bringing inflation down by the late 80s, which culminated in consistently low single digit inflation by the 90s and robust economic growth. What this shows is that although monetary policy has its limitations, central bankers’ credibility can push an economy into its full employment phase by managing consumer and market expectations.

What is the context for Japan? For a brief summary of Japan’s problems deemed the Lost Decade, please read here. Japan came out of the 90s and 2000s with a backdrop of low GDP growth, low inflation and low economic morale. It has been battered by a phenomenal stock and property market collapse in 1992. Even though Japan has engaged in expansionary fiscal (increased government spending) and monetary policy ( lowering interest rates ), it did not registered high single digit GDP growth ever again. Inflation has been consistently very low and sometimes in deflation period, and this has created a mood of economic depression in Japan’s society.

One of the main cause of this in my opinion was the negative impression exhibited by Japan’s policy makers that monetary policy won’t be that effective in countering the recession, given that interest rates were already low and that more expansion would not do much. Because policy makers were stuck in a mood of negativism regarding monetary policy, most market participants expected that policy makers won’t do what it takes to bring the economy back out of recession, and would instead “conserve policy ammunition”. Krugman argued that BOJ did not do enough to combat the recession and raise expected inflation target or in his own words “be irresponsible”. In other words, he believed BOJ should be even more aggressive in setting interest rates lower which is also consistent with Bernanke’s point in the speech below.

“I emphasized the need to set an inflation target high enough to provide some buffer against deflation, and I noted that temporary overshoots of the target to compensate for prior inflation shortfalls could be warranted following a period in which rates are constrained by the effective lower bound.” (Bernanke Speech at BOJ, 2017)

For those not familiar with the BOJ not being aggressive enough, let’s think of it in an intuitive mathematical way,

Nominal Interest Rate ( R ) = Real Interest Rate ( r ) + Expected Inflation ( E(P) )

The identity above is an approximation to how central banks’ interest rates interact with inflation. The central bank sets R, while it influences the E(P). The lower R, the higher E(P) should be. Low interest rates increase consumption ( savings return gets lower, so consumers rather hold cash and spend ) and investment ( cost of borrowing gets lower ). Ideally, if a central bank decreases R, E(P) increases and this cause a larger decrease in r. But what happens if E(P) is low or even negative (deflation environment) for whatever reason? Real interest rate, r’s decrease would be less with a decrease in nominal interest rates, R. Part of the reason for Japan’s lost decade with deflationary environment was that expected inflation was very low, and renders monetary policy effectiveness questionable. This is what economists call the liquidity trap. The way to think about Japan’s low condition in the 90s, 2000s and even now, is that market and consumers do not expect inflation to be high in the future and that expansionary monetary policy is more constrained as it approaches the zero bound. ( Japan now has negative nominal interest rate, precisely to increase E(P) and decrease r ).

But to be fair to BOJ, Richard Koo in his book, the Holy Grail of Macroeconomics, puts forward the interpretation that Japan was stuck in a balance sheet recession. A balance sheet recession happens when companies and individual’s objective switch from profit maximisation to debt reduction, that is we pay our debts first rather than investing and consuming. Japan had a big debt overhang from its stock and property market collapse, with valuations collapsing but debt principal still remaining the same. To understand this better, individual or company A takes up $100 of debt from the market to buy an apartment worth $100 at the time. As the property market collapses, the apartment now is only worth $10 if A was to sell it. A is now straddled with a $10 worth company with a $100 debt its principal. So what would A do? Declare bankruptcy or channel its existing wealth to repay the debt. A effective would have made a loss of $90.

For the accountancy majors out there, a good way to look at it would be


Before Market Collapse

After Market Collapse

Asset Liability Asset Liability
Apartment, $100 Debt, $100 Apartment, $10 Debt, $100
  Equity   Equity
  Profit/Loss, $0   Profit/Loss, -$90

An expansionary monetary policy in this case to boost consumption and investment would end up ineffective if players are more interested in reducing their debt burden first. Some people at this point would be wondering, if interest rates are so low already, wouldn’t refinancing would be the better way? Very good point, but it also depends on whether banks would borrow it to you. Looking from the banks perspective, they have just suffered high defaults which has hit their balance sheet and P&L hard. More write off’s and impairment losses will be recorded in its asset and profit and loss. Banks would be more risk averse and weigh more of its portfolio to the lower risk customer pool for business to recover. Couple that with extremely low interest rates which directly means lower interest revenue, banks would rather just keep their money in cash or reserves. This is precisely what happens in another country recently, namely the US.

There were actually a lot of very interesting points raised by Bernanke in his speech but I am going to end it here for now. But if you are interested in this topic, please read the speech here by Bernanke. Feel free to ask any questions regarding this or suggest other explanations =).

Post Picture from Critical Financial


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