Last Friday Japanese Prime Minister Shinzo Abe resigned for health reasons. 1 1 Close “Abe, Japan’s Longest-Serving Premier, Resigns Due to Health,” Bloomberg, 8/28/2020. It was not the first time: in 2007, he left the post after only a year in office and little impact on the country. In this second run, he was the longest serving PM in Japan’s history. It’s too early to evaluate what his legacy will be, but from the narrow perspective of an investor, his Abenomics policies are as relevant now as they were when he came into office in 2012. As you may recall, Abenomics consisted of three arrows: easy monetary policy, fiscal stimulus and structural reform. 2 2 Close https://www.japan.go.jp/abenomics/_userdata/abenomics/pdf/170508_abenomics.pdf With Abe leaving the world stage, it’s the perfect time to reexamine the first arrow and what lessons it has for us today.
When Abe was elected, he almost immediately replaced Bank of Japan Governor Masaaki Shirakawa with the more dovish Haruhiko Kuroda. To put this in perspective, for much of the 1990s and early 2000s Japan was unique among developed countries in its struggles with disinflation and outright deflation. 3 3 Close Now many countries have copied them. During that period, the BOJ’s policies had been inconsistent. In some ways, it had been very proactive in fighting disinflation: it brought rates to zero and invented modern quantitative easing. But it never really shook its fear of higher inflation and conducted two ill-fated hiking cycles in the 2000s. 4 4 Close Cycles may be a bit of an exaggeration. They hiked and then reversed course. Looking back, it’s difficult to understand why BOJ members were so concerned about inflation. 5 5 Close There was also an argument some folks made at the time that raising rates was part of normalizing policy. The argument was sort of backwards. It went that if inflation were at normal levels – say 2% – then rates would be somewhere around 4%. Therefore, bringing rates up was part of getting inflation and policy back to historical levels. It’s a shame it doesn’t work like that or economic policy would be much easier.
Kuroda set an inflation target of 2% and instituted an aggressive policy of asset purchases. He later added several innovations to the BOJ including negative rates and yield curve control, but perhaps his most important action was to end this preemptive monetary tightening. If this sounds familiar, it’s because many central banks are struggling with the same issues as the BOJ. Last Thursday, U.S. Federal Reserve Chairman Powell announced some changes as the result of a monetary policy review, and parts of these changes sound like they were taken directly from the first arrow.
The Fed adopted an inflation target before the BOJ did, but still finds itself facing chronic disinflation. To correct that, the Fed is moving to what is known as flexible average inflation targeting (FAIT). 6 6 Close Not to be confused with Fiat, which is a car. Or fiat, which is the type of currency the Fed manages. This means that the Fed is serious about making the inflation goal symmetric, and it will allow inflation to run “moderately” above 2% to offset time it spends below the target. In other words, there will be no more preemptive rates hikes to keep inflation below target.
The Fed is also changing how it views the employment part of its mandate. While FAIT is a move to a symmetric inflation target, the Fed is taking an asymmetric view of employment. It will only try to correct “shortfalls in employment,” implying that it won’t hike rates if unemployment gets too low. 7 7 Close “New Economic Challenges and the Fed’s Monetary Policy Review,” Jerome Powell, 8/27/2020. This brings up the question as to why the Fed would fight low unemployment in the first place. A doctor wouldn’t give you medicine for being too healthy.
Like the BOJ’s inflation concerns, it is a relic of past policy errors. In the 1960s and 70s, many economists believed that low unemployment could lead to inflation through wage pressures. There may be some logic to this and other “Phillips Curve” arguments, but some folks took them too far. 8 8 Close We will protect their identities. They posited that it might be desirable to have high inflation in pursuit of lower unemployment. The U.S. got higher inflation, but unemployment did not fall. The Fed’s previous attitude toward unemployment can be seen as an overreaction to that period.
So, what does the Bank of Japan’s experience tell us about the likely efficacy of the Fed’s new framework? The Bank of Japan did not achieve its 2% target, so some view it as a cautionary tale. That is probably not the best interpretation. Although the BOJ was unable to meet its goals, it was able to generate positive inflation for most of Abe’s time in office. The BOJ proved that aggressive monetary policy can affect even the most stubborn of economies, one with strong disinflationary inertia and unfavorable age demographics.
In Japan, the second and third arrows were never fully realized. Consumption tax hikes dented economic confidence, and many economists view the reform efforts as disappointing. For the Fed, achieving its 2% target may depend on whether fiscal stimulus continues. 9 9 Close Better not to speculate on structural reform. So far there has been more cooperation between the Fed and Treasury than there was between the Ministry of Finance and the BOJ.
The initial reaction from markets was essentially to yawn at the Fed’s new framework. Some commentators have suggested that it was no surprise that the Fed had essentially communicated the changes in previous speeches. Others think that market participants were expecting more changes from the Fed. Either of those interpretations are reasonable, but it is also possible that investors had Abenomics on their mind and were skeptical that the measures would succeed in bringing inflation back to 2%. 10 10 Close It’s also a question as to whether that is the right goal for the Fed to try to achieve. But that’s for another week. That’s probably the wrong way to remember Abenomics.
What We Are Watching
China Trade Data (Monday)
The Chinese economy has experienced an uneven recovery in the months since the country began to loosen lockdown measures. Data from the National Bureau of Statistics has shown a prompt rebound in industrial activity, while consumer spending has languished. One side effect of this divergence between production and consumption has been an increase in the Chinese trade surplus, which has widened to multi-year highs. If trade data this month continues to show weakness in imports relative to exports, it would suggest that this dynamic has persisted. While a larger trade surplus may provide some support to the renminbi exchange rate, it could also exacerbate trade tensions with the United States. A surplus-reducing pickup in Chinese imports might therefore be viewed positively by markets.
European Central Bank Meeting (Thursday)
In March and April, the European Central Bank (ECB) acted aggressively to support the Eurozone economy and financial system. The central bank launched a new asset purchase program and offered liquidity to the banking sector on attractive terms. While no additional measures have been announced recently, the ECB has maintained dovish guidance, stating that policy interest rates will “remain at their present or lower levels” until the inflation target is achieved, and that asset purchases will continue “until at least the end of June 2021 and, in any case, until the Governing Council judges that the coronavirus crisis phase is over.” 11 11 Close ECB President Christine Lagarde: “Introductory Statement, Press Conference,” 7/16/2020. Developments in recent weeks have presented some new challenges for the ECB. Coronavirus cases have risen significantly in several European countries, which could hinder the pace of economic recovery in the months ahead. The euro has appreciated relative to the dollar and other major currencies, potentially dampening already-low inflation. Major changes to policy appear unlikely this month, but market participants will be watching President Lagarde’s press conference to assess whether policymakers might be preparing additional action in the months ahead. Following press reports that the ECB is concerned about euro strength, investors will likely be particularly focused on how President Lagarde handles questions around the exchange rate. 12 12 Close Financial Times: “Rising euro stokes ECB worries over falling prices,” 9/3/2020.
U.S. CPI (Friday)
Core inflation in the U.S. posted its largest monthly gain in 30 years in July, as various categories impacted by the pandemic continued to reverse the deep declines experienced during the lockdown period. These price indices include airfares, apparel, vehicles, and hotels. However, the sharp monthly rebound was not enough to take these categories out of year-over-year deflation. All in all, core inflation remains well below its pre-pandemic level, albeit moving in the right direction. With the Federal Reserve formally aiming to deliver moderately above 2% inflation for some time, a strong and sustainable recovery in consumer demand, coupled with additional monetary and fiscal stimulus, will likely be required to achieve the feat. Next week’s data will provide an update on the progress made toward such higher inflation. Should the data surprise to the upside again, market participants could interpret stronger-than-anticipated underlying demand, which would support risk assets in the U.S.