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 2014. Annual growth of broad money M3 stood at 2.5% in March 2014; 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.
The MPC supposedly places significant weight on an estimate of the “medium-term equilibrium unemployment rate” in calibrating its policy stance. The August 2013 Inflation Report, for example, stated that “The gap between actual unemployment and the medium-term equilibrium unemployment rate is a measure of effective slack in the labour market, and is likely to be most relevant for assessing wage pressures over the MPC’s three-year forecast period.”
So what is the Committee’s current judgement about this crucial policy metric? The May Inflation Report, on close inspection, is contradictory. The text at the top of page 30 of the Report refers to a current estimate of 6-6.5%. Chart 3.7 on page 28, however, contains a first-quarter figure for the “unemployment gap” – the difference between the actual and medium-term equilibrium rates – of 0.9%. Since the MPC expected actual unemployment to be 6.7% in the first quarter, this implies an equilibrium rate of only 5.8%.
How has this contradiction arisen? One possibility is that Bank of England staff generated the 5.8% estimate but the MPC majority refused to endorse their assessment, preferring a 6-6.5% range. Chart 3.7 may have been retained in the Report owing to an editorial insight, or because the still-significant unemployment gap shown supports the dovish policy stance of Governor Carney.
The single-month unemployment rate fell to 6.45% in April, within the MPC majority’s 6-6.5% range for the medium-term equilibrium rate. The MPC believes that there is additional labour market slack associated with part-timers working fewer hours than they would like, although the implications of this shortfall for wage pressures is uncertain. With a further unemployment decline assured, the majority position suggest an interest rate rise before end-2014.
Governor Carney, of course, is strongly resistant to such a scenario, and may press for a downward revision to the estimated range for the medium-term equilibrium unemployment rate in the August Inflation Report, probably to 5.5-6%. This change would be presented as a response to new information; it would, in fact, simply make explicit an assumption already incorporated in the Bank’s May projections.
Labour market statistics released today are a mixed bag, showing stronger quantity developments than forecast by the MPC but surprisingly low earnings growth. Earnings weakness may not prevent the MPC from turning more hawkish, partly because it reflects sluggish productivity.
The unemployment rate fell to a below-consensus 6.6% over February-April, with the April single month estimate at just 6.45% – see first chart. This supports the forecast here that the rate will finish 2014 at 6.0% or below, undershooting the May Inflation Report projection of 6.3% in the fourth quarter.
The jobless rate is plunging because of strong demand for workers rather than US-style labour force weakness. Aggregate hours worked in the economy rose by 3.3% in the three months to April from a year before – the fastest annual growth rate since 1989. With the Inflation Report projecting a 3.6% GDP increase in the year to the second quarter, the suggestion is that productivity, as measured by output per hour, has barely budged. The MPC’s forecast of 1% productivity expansion in 2014, implying a larger rise in the year to the fourth quarter, is off track.
Annual growth in average earnings has been distorted by income shifting a year ago to game the cut in the top income tax rate from 50% to 45%. Taking a six-month moving average to minimise this distortion, earnings are rising at about a 1% annual pace. This is probably about 1 percentage point below the MPC’s expectation at this stage but, as noted, productivity is undershooting by a similar amount.
Part of the story is a shift of employment into lower wage / productivity activities over the past year. Earnings growth would be 0.5 percentage points higher in the absence of this composition shift.
The MPC may downplay earnings weakness partly because of the productivity offset but also because more timely survey evidence suggests rising wage pressures, while slack is eroding faster than expected. From employers’ perspective, the claim that significant slack remains is inconsistent with emerging skill shortages and a further rise in the vacancy rate to a six-year high – second chart.
The forecast of a summer rebound in global growth remains on track, according to the short- and longer-term leading indicators followed here.
The indicators are derived from OECD data and have led growth turning points by 2-3 months and 4-5 months respectively in recent cycles. They weakened during the second half of 2013, correctly predicting that the global economy would slow in early 2014. Six-month industrial output growth* peaked in November / December 2013 and fell to a 10-month low in April – see first chart.
The longer-term leading indicator, however, started to recover in January, with the short measure following in February. Industrial output growth is probably now reviving from a trough reached in May.
The short-term leading indicator rose again in April while the longer measure was little changed. This suggests that growth will pick up through the summer before stabilising at a higher level at the end of the third quarter.
The stalling of the longer-term indicator in April reflected a decline in the G7 component – second chart. The G7 measure may have been temporarily distorted by Japanese data volatility due to the recent sales tax hike; the April set-back, in other words, may be reversed in May-June. The E7 component, meanwhile, continues to strengthen, supporting optimism about emerging market equities.
The forecasting approach here uses the leading indicators in conjunction with an analysis of real narrow money trends. Global real narrow money expansion slipped back in April, but this mainly reflected the impact of the Japanese sales tax; trends elsewhere remained solid – see previous post. Global economic acceleration may be over by end-summer but the monetary / leading indicator evidence has yet to suggest a subsequent slowdown.
*G7 developed economies and E7 emerging economies.
The MPC lowered its unemployment rate projections again in the May Inflation Report but is probably still underestimating the speed of decline. The jobless rate may end 2014 at or below 6.0%, i.e. close to the MPC’s current central estimate of non-inflationary “medium-term equilibrium” of 5.8%.
The unemployment rate fell from 7.8% to 6.8% in the year to the first quarter of 2014 as GDP grew by 3.1%. The MPC expects GDP expansion to remain at 3.0-3.25% annualised through the fourth quarter. This suggests that the jobless rate will continue to decline by 0.25 percentage points (pp) per quarter, implying 6.0% by year-end.
The MPC, by contrast, forecasts that the quarterly fall will slow to 0.15 pp, yielding a 6.3% unemployment rate by the fourth quarter. This rests on an assumption that productivity growth will start to “mean revert” as the expansion matures. The same assumption was made in the February and November Inflation Reports but little recovery is yet evident. This is consistent with experience after the last major productivity “shock” in the 1970s, when performance remained weak for many years – see previous post.
Hopes of near-term productivity improvement are not supported by labour market leading indicators, which have yet to suggest any slowdown in employment gains or unemployment erosion. Six-month growth of the stock of vacancies, indeed, has risen further from 8% in October to 14% in April. The PMI services employment index regained its October peak in May – a 17-year high. The net percentage of consumers expecting a rise in unemployment, meanwhile, collapsed to a 16-year low last month – see chart.
These trends imply that productivity remains stagnant or else economic growth is even stronger than expected – either possibility, of course, would warrant greater inflation concern. Pressure for an early interest rate increase may continue to build.