This is is a guest post from Philip Pilkington, a writer and research assistant at Kingston University.
In January of this year I noted that the Japanese government was embarking on a stimulus programme and briefly enquired into whether it would likely work or not . At the time media commentary was mixed. Some were saying that it would be a complete failure while others were overflowing with optimism. I was slightly more reserved.
The problem with Japan is that they seemed unable to get consumers to open their wallets for any sustained period of time. In 2009 when the Japanese government ramped up spending in response to the 2008 downturn the economy picked up briefly. However, once the government retracted its spending the economy fell back into a slump as consumers retreated back into their characteristically frugal state.
In the above piece I noted that the best approach for the Japanese government would be to undertake a far larger direct fiscal stimulus program. However, since this was unlikely to happen I considered how far they might get with a limited stimulus combined with a devaluation of their currency that would promote Japanese exports. I pointed out that the yen had strengthened in relation to the dollar since the last stimulus in 2009 and that to even get back to those levels it would need to devalue by another 10 per cent. As of this week that devaluation has taken place and the yen is back to roughly 2009 levels versus the dollar – whether this will be enough to promote the export growth needed for recovery is another question entirely.
In the meantime, however, attention has turned away from the fiscal stimulus and towards the latest round of Quantitative Easing that has been announced by the Japanese central bank. The bank last week promised to double the monetary base over the next two years. In response to this news market speculation has, as previously mentioned, driven the yen back to 2009 levels against the dollar. It had been stuck above this for the past few weeks.
So far, so good; but the real question is: will the latest QE program have anything more than short-term effects on the strength of the yen? After all, the Bank of Japan started these QE programs back in 2001 and they have not met with much success. Sure, an announcement that they are doubling the monetary base may cause market speculators to sell the yen in the short-run, but can these effects be sustained or should we focus our attention on more fundamental issues?
The best measure of the extent of QE in Japan at any given moment in time is probably the most direct: that is, the level of “current account balances” of the commercial banks. As the Federal Reserve Bank of San Francisco notes, it was by increasing these current account balances that the Bank of Japan initiated their QE programs.
Since the fall in the yen is perhaps the most immediately obvious effect of the recent QE program let us first take a look at how this relationship has played out over the last decade and a half in Japan.
As previously noted the BoJ undertakes QE by increasing the “current account balances” – the red line. As we can see the program was run from March of 2001 until early 2006 when the bank quickly sucked cash out of the system by reducing the current account balances. QE then began once again rather slowly in 2008 and the sped up in late 2010.
Certainly it is true that the yen has weakened over the period of QE. However, on careful examination it should be clear that this weakening started in late 1999, at least 18 months before the first QE program. In addition to this when the Bank of Japan cut back on QE in early 2006 the yen continued to depreciate. The yen also sharply appreciated in the third quarter of 2008 despite the fact that this was when the Bank of Japan began another round of QE – this was, however, probably due to the markets racing to hold liquid assets as the 2008 financial crisis shook the world.
All of this considered it seems that while the yen has indeed been in a downward trend in the period of Japanese QE, it is by no means clear that the weakening was due to the QE. Indeed, careful examination of the above graph makes one rather sceptical that the QE program had significant long-term effects on the value of the yen at all. This should be kept in mind as the markets obsess over the short-term weakening of the currency that we have seen over the past few days.
Japanese officials are also hopeful that the latest round of QE will have substantial effects on inflation, which has been dipping in and out of negative rates in Japan over the past two decades. Again we can plot the inflation rate against the current account balances in order to see if the QE programs have had any substantial effects.
As was the case with the exchange rate, the effects that QE has had on inflation since it was initiated in March 2001 are extremely unclear. When the program was initiated the economy was experiencing deflation and it is not clear that this deflation was overcome at all between 2001 and 2006. Pointedly, however, less than 18 months after the BoJ halted the program in 2006 the economy experienced a short-lived spike in inflation. This seems to strongly suggest that the rate of inflation has no positive relationship to the current account balances at commercial banks. This should lead us to conclude that the QE programs do not have any appreciable effects on the rate of inflation.
Some may have also noticed that Japanese stock markets rallied on the BoJ’s announcement last week. This has largely been following trend as the Nikkei has been gradually climbing on the announcement of the stimulus in January. However, the announcement of a new round of QE has certainly led to a short-term market rally. So, let us turn to the relationship between the Nikkei and the previous rounds of QE to see if there is any relationship.
Here we can detect some relationship between the two variables. It is clear that when the first QE program was initiated in 2001 the stock market was in the dumps. As the current account balances at commercial banks piled up the stock market began to rise. It is also clear that it took some time for the stock market to respond to the first round of QE. The stock market only began to truly rise two years after the program had been initiated and only after it kicked into high-gear around the start of 2003. The stock market rising together with the rise in current account balances (i.e. QE) can be seen between the two black lines on the above graph.
If we consider that the latest round of QE was only really stepped up in late 2010 we might conclude that, given the two year lag of the last rally, the present stock market rally in Japan may actually be sustainable. This is not to say, of course, that people should dump all their savings into the Nikkei but the data does suggest that there is a relationship between QE and stock markets, although it is by no means clear how strong this relationship is. However, it seems that we can say with some confidence that QE can drive stock prices; certainly we can be more confident of this than it having any sustained effects on inflation or the exchange rate.
This is not particularly surprising. When the banks are flush with cash there is every reason to think that they will seek to move into riskier assets in order to try and earn a decent return; thus a rally in equities makes sense. This rally can then build momentum so that even when the QE is scaled back, as it was in early 2006, share prices can continue to climb until they are interrupted by something else – which, in the case under scrutiny, was the 2008 financial crash.
All in all it is unlikely that the BoJ’s latest QE program will have any substantial effects on the real economy. For such effects we need to focus firmly on the level of investment and consumption activity together with the trade balance. However, the QE program does seem likely to be able to support Japanese share prices to some extent; although we should naturally be cautious in making any firm predictions in this regard.
One more note on the Japanese trade balance. Although the current account has recently swung into surplus on the back of a weakened yen, the trade balance remains in deficit. This is because, since the Fukushima disaster in 2011, the Japanese have had to import far more fuel and gas. While it remains unclear when they will get their nuclear reactors back to full capacity their doing so should be considered a major signal that economic growth might return to the Eastern island. Such a consideration also provides a strong case for why the Japanese government should extend their stimulus program to promote green energy programs moving into the future. Yet another example, as if we needed one, that the problems faced by most developed economies today have far more to do with deficient demand and resource misallocation than they have to do with anything that takes place on the reserve accounts of commercial bank computers.