An April post argued that Japan’s expanded QE would have a smaller positive impact on monetary conditions and the economy than many believed, because official bond purchases were likely to be offset by stepped-up selling by banks – such sales reduce the broad money supply and put upward pressure on short-maturity yields.

Consistent with this view, domestically licensed banks reduced their central government bond holdings by a monthly record ¥10.5 trillion in April, outweighing a rise of ¥8.7 trillion on the BoJ’s books. The fall is equivalent to 21% of planned official JGB purchases for the whole of 2013 (i.e. ¥51 trillion).

The impotence of QE in Japan and elsewhere is a consequence of banks targeting a fixed level of overall liquidity, i.e. central bank reserves plus government bonds. QE forces banks to hold more reserves, causing a reduction in their demand for bonds. The BoJ plans to inject ¥60 trillion of reserves this year so banks should continue to run down their holdings – ¥156 trillion at end-April – to prevent their overall liquidity from ballooning.

Japan’s economy is expected here to grow moderately through late 2013, a forecast consistent with recent unexceptional real M1 expansion – see Tuesday’s post. Nominal M1 trends need to strengthen significantly over the next 12 months if real growth is to remain consistent with economic recovery, assuming that the government implements the planned 2014 sales tax rise – expected to boost inflation by about 2 percentage points.