Japan’s QE programme has failed to boost money supply growth, despite its massive scale. This supports US / UK evidence that the monetary impact of QE has been greatly exaggerated by its supporters. The weak monetary response implies that QE has had little influence on economic developments in the three countries. Its main effect has been to encourage speculative behaviour in financial markets, increasing the risk of asset price bubbles.

Incoming Bank of Japan (BoJ) Governor Kuroda significantly expanded its QE bond-buying operation in April 2013. Annual growth of broad money M3 stood at 2.5% in March 2013; some QE optimists expected the new blitz to drive it up to 10%. There were initial indications of a modest positive effect, with annual M3 expansion reaching 3.5% in November. It has since fallen back to 2.6%, as of May.

Why has the liquidity created by the BoJ to buy securities failed to boost the money supply? An answer to this question requires an analysis of the “monetary counterparts”. The “money supply” is the main liability item on the banking system’s balance sheet. Since the system’s total assets equal liabilities, money supply changes can be “explained” by movements in other balance sheet items. The chart shows the contribution of these other items to annual broad money growth.

QE has had the expected expansionary impact on  banking system assets: the contribution of the BoJ’s lending to the government to annual broad money growth rose from 3.2 to 5.9 percentage points (pp) between March 2013 and April 2014* (blue bars). This increase, however, has been neutralised by larger sales of JGBs by banks: a reduction in their lending to the government subtracted 2.8 pp from money growth in April, up from 0.9 pp in March last year (red bars). Banks are selling mainly because QE has boosted their reserves at the BoJ, so they need to hold fewer JGBs to meet their liquidity targets.

There has been an additional small drag on broad money growth from a slowdown in bank lending to other Japanese residents: such lending contributed 0.9 pp to money growth in April versus 1.3 pp in March 2013.

To a first approximation, therefore, QE has amounted to a large-scale swap of JGBs and reserves between the BoJ and other banks, with no impact on the money supply. The increase in banks’ reserves, moreover, has not resulted in an expansion of their lending to the rest of the economy.

Remarkably, the joint contribution of BoJ and bank lending to the government to broad money growth is smaller now than when QE was launched in October 2010 – 3.3 pp versus 3.1 pp (sum of blue and red bars). Banks were then driving the expansion, buying JGBs to boost their liquidity ratios.

The BoJ is committed to maintaining securities purchases at their current pace but the monetary impact should continue to be neutralised by bank selling. The stock of bank lending to the government still amounts to 25% of the broad money supply so the recent rate of reduction could be sustained for many years.

The BoJ could try to achieve more bang for its buck by buying equities rather than JGBs. Banks, however, would probably still sell JGBs as their reserves expanded so there is no guarantee that the money supply impact would be larger. Higher equity prices, in isolation, would be unlikely to provide even a short-term boost to the economy, given the absence of a “wealth effect” in Japan.

Rather than BoJ intervention, any rise in broad money growth is likely to be driven by a pick-up in bank lending to the private sector or a stronger balance of payments position**. “Abenomics”, however, has so far failed to stimulate credit demand, while the balance of payments has deteriorated recently, reflecting both a lower current account surplus and net direct / portfolio investment outflows.

Current monetary trends suggest modest economic growth and low inflation – probably beneath the BoJ’s 2% target***. Such a scenario is not unsatisfactory given Japan’s demography and could have been achieved without QE.

*The counterparts analysis is not yet available for May.
**A basic balance (i.e. current account plus net direct / portfolio flows) surplus results in a rise in the banking system’s net foreign assets, included under “other counterparts”.
 ***Stripping out sales tax effects.