It’s been a while since the last post on this blog. 5 months and one day, to be exact. But we’re back! And it seems to be a good time to return. For anyone as interested in monetary economics as I am, we are probably experiencing the most fascinating real-world experiment in the field of monetary policy undertaken in recent history. It’s also all happening in one of the most unlikely places one might image: “how did a lost decade turn into two” Japan. The timing of it all is fascinating in and of itself, with pundits like Paul Krugman coming up with interesting analogies and what seem to be pretty convincing theories – Japan seems to have discovered its “moral equivalent of space aliens”. Indeed, even if one believes the threats of a rising China (with its enormous stake in international trade and thus peace in the region) are overblown, there is good reason to argue that Japan was scared out of complacency and into action after losing their spot as second biggest economy in the world. Oh, and the Tsunami thing, of course. Let’s just say times have been rough.
I cannot stress enough how important the actions recently taken by the Bank of Japan are for the economics discourse in general. The very heart of the debate concerning how to fight severe economic slumps is being tested. Anyone following Krugman and Sumner (or any number of other well-known econobloggers) lately might have noticed that there is considerable disagreement, at least rhetorically, with regards to the power of monetary policy at the zero lower bound. Indeed, the very notion of the liquidity trap as a serious obstacle to monetary policy is being put into question right now!
Below we have a graph showing how the announcements by the Ban of Japan have altered inflation expectations using a couple of different proxies, and clearly, after around two decades of close to zero inflation (everything before the time where the graph starts doesn’t look much different), inflation expectations recently have spiked. Well, spiked might be a bit of a strong word. They’re still far from the 2% target the BoJ set for itself, which means it needs to do more, but the sole fact that there was a reaction at all is huge. It tells us that the right question to ask is not whether central banks loose traction when hitting the limits to conventional monetary policy, but whether they are willing to do what it takes in order to gain traction again.
Now to be fair, if stable prices are what you want, meaning an average of 0% inflation over a given period of time, then the Bank of Japan has been far and away the most successful central bank in the world. Ever. But then again, if you like to look at some of the other, arguably more important macro indicators that might prove better measurements of how well an economy is doing, then I would say that the price of “preventing” prices from rising is pretty high. And not only seem inflations expectations to be finally on the rise, the Japanese Yen has also dropped to its lowest value compared to the US Dollar in 4 ½ years. And just for the record: both the rise in inflation expectations and the drop in the value of the Yen are features, not bugs, of the new policy. They are signs of improvement, not impending doom.
How the whole story will play out is still open, but so far it looks like a huge success for anyone arguing that central banks need to do much more, not less, once the zero lower bound is reached, and that there are indeed ways of getting through to the real economy if one is willing to try. And on that note I shall leave you with the wise words of one who presided over a fairly ambitious historical experiment in economics himself, Franklin D. Roosevelt: “The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something“. It was about time we re-learned that lesson.