Monday, January 14, 2013

Forward Looking Markets in Japan

Even though Shinzo Abe has not yet cemented in a new era of Japanese monetary policy, markets have already been preparing for such an event. The market response is a good illustration of how markets act in a forward looking manner.

First, we need to identify when the international community started to focus in on Shinzo Abe. For this, we can look at Google's international search intensities:

From here, we can identify the time around December 15th to be the starting point. Now let's take a look at how markets have responded since then.

First, the exchange rate. Easier monetary policy raises aggregate demand, accelerating NGDP growth and depreciates the currency. Even though the statutory monetary policy framework hasn't changed, the yen has already lost around 7% of its value relative to the dollar since December 14th:

Exhibit 2, the Stock Market. In the same time period, the Nikkei 225 index has risen over 9%. To give this some perspective, almost one-third of the gains over the course of the past year have been the result of the past month of advances.

These statistics are quite striking when you think about the policy controversy surrounding Japan's "lost decade" and the hundreds of trillions of yen that went into public works programs.

Also, these statistics are quite interesting for the "long and variable leads" perspective on monetary policy. Historically, the money supply has not had a large effect on real variables such as GDP. In fact, if you really dug into the 5 year rolling correlations, you would find that, most of the time, quarterly money supply growth actually had a negative correlation with quarterly real GDP growth in that period.

Yet just in the past month, a few "open mouth operations" have seemed to dramatically change market perceptions of monetary policy. This suggests that the mechanical money printing is quite powerless without effective expectations management. As such, there should be significant gains to Shinzo Abe's drive to change the Japanese monetary regime.

On a separate non-economic, purely speculatory note, I'm not sure how the nationalism issues brought up by Noah Smith would interact with this drive to make monetary policy more inflationary. On one hand, if monetary policy is seen as a driver to achieve national ambitions, then the nationalist drive may reinforce the increase in aggregate demand. That would be good. But the worrisome possibility, which worries me more than the possibility that Shinzo Abe will give up on monetary policy, would be that the monetary policy stimulus will be too effective and further stoke nationalist ambitions. The last thing we need is some stupid quibble over the Diaoyu islands that leads to a face-losing and economy destroying outcome for everybody.

Update 1/19/13:

Scott Sumner emails me with the following comment:

"Abe actually started pushing for a 2% inflation target during the campaign, in mid-November. The day of his first speech is the exact the the huge stock rally began, and the exact day the yen began falling sharply. I did a post that day, or perhaps the next. 

It's hard to disentangle money printing and expectations. Think of the following thought experiment: The central bank doubles the money supply and is expected to cut it in half 3 days later. Everyone agrees that there is little effect on markets or AD. So in some sense we are always implicitly making assumptions about monetary policy. On the other hand, I can easily envision where big changes in the money supply also contain information about future expected monetary policy, even if not made explicit. So I can envision QE "working" at least to some extent, even w/o an explicit promise regarding future policy."
Looking back at the data, I should have been more careful with the timing issue. Although the November 15th spike looks minimal, it is only because the December spike was much larger. Focusing in on that one month of the Google data yields the following graph:

On the relationship between money printing and expectations management, I agree with Scott that money "printing" policies, such as QE, can have significant effects even without explicit open mouth operations. The Fed doesn't need to announce a NGDP target for those policies to have effect. But the point with Japan is that effective communications policy can enhance monetary policy. Given that money supply expansion hasn't been sufficient in the past, perhaps a more powerful target will do the trick.


  1. "[T]he mechanical money printing is quite powerless without effective expectations management." I think this is true but worry it is becoming an orthodoxy. We should actively search for counterexamples or counter-stories in which expectations cannot offset printing -- who knows, it might end up supporting our argument that monetary policy is all about demand expectations if we find that there's basically no such counters.

  2. Your comment strikes a chord with some of my current thoughts on how to take market monetarist research further. What I think is important to do for that project is to work to define what it means to have certain expectations and what it means to meet or exceed them.