The economic strategy of the Abe government and its Bank of Japan (BoJ) placemen is to employ monetary policy stimulus to push growth up to “escape velocity” before hiking the consumption tax to begin closing the huge budget deficit. Current monetary trends, however, suggest that the tax rise will hit before the economy has reached orbit.
The government will reportedly announce next week that it is proceeding with plans to raise the consumption tax from 5% to 8% in April 2014. A complementary “stimulus” package is expected to be unveiled but will be a fraction of the size of the tax grab.
The strategy assumes that the economy will be expanding strongly next spring under the influence of the BoJ’s ultra-aggressive QE programme. While money growth rates have firmed, however, the surge predicted by optimists has failed to materialise – see first chart. This is partly because the money supply impact of the BoJ’s bond purchases has been offset by stepped-up selling by banks* – a possibility envisaged in a previous post.
The rise in nominal monetary expansion, moreover, has been more than matched by faster consumer price inflation. Six-month growth in real narrow money M1, therefore, is no higher than a year ago and has retreated recently – second chart. This suggests that the economy will be losing, not gaining, momentum in spring 2014, allowing for the typical half-year lag between real money shifts and demand / activity.
The monetarist perspective here is that raising indirect taxes inflicts more short-term economic damage than other forms of fiscal tightening, because there is an immediate, significant impact on the price level, resulting in a squeeze on real money holdings. UK economic growth withstood fiscal restraint in 2010 but ground to a halt after standard-rate VAT was raised from 17.5% to 20% in January 2011. The last – smaller – hike in Japan’s consumption tax in 1997, of course, kicked off a severe recession (extended, admittedly, by the Asian / LTCM crises).
The latest six-month rises in M1 and consumer prices were 2.8% and 0.8% respectively, giving a real M1 increase of 2.0% (all numbers are seasonally adjusted, not annualised). The tax hike will boost the CPI by about 2.5%, suggesting that six-month inflation will climb temporarily to about 3% next spring. Unless nominal growth rises, therefore, the six-month change in real M1 will fall to zero or turn negative – unlikely to be compatible with continued economic expansion.
Other money measures, and bank lending, are growing more slowly than M1, implying a higher risk of real contraction.
It is possible that QE is operating with a lag and will push money growth rates significantly higher before the tax hike hits. The view here is currently agnostic bordering on sceptical; increased caution on Japan’s economic and equity market prospects will be warranted if monetary acceleration fails to materialise by end-2013.
*The BoJ’s holdings of government bonds and bills rose by ¥31 trillion between end-March and end-July; banks reduced their holdings of central government securities by ¥24 trillion over the same period.
