On April 4, the new governor of the Bank of Japan (BOJ), Haruhiko Kuroda, followed through on the promise of Prime Minister Shinzo Abe’s government to stimulate the economy through their own form of quantitative easing. In announcing that the BOJ would be buying the equivalent of $79 billion of various securities per month, Japan joined much of the rest of the developed world in trying to stimulate growth through monetary activity. The Federal Reserve and Bank of England have been engaged in such activity since early 2009. Last June, Mario Draghi, President of the European Central Bank (ECB) began, at least verbally, to move the ECB towards easing. Japan really had no choice but to join the group.
A significant consequence of Japan’s reluctance to aggressively use monetary policy was a currency that had appreciated against most of their trading partners. For the period from March 2009, the beginning of Federal Reserve quantitative easing, to November 30, 2012, two weeks before the Abe government was elected, the Yen had appreciated by 16% against the U.S. dollar, 6% against the British Pound and 18% to the Euro. The consequence of this was two-fold. A rising currency makes imports less expensive. This reinforced the deflationary trend already in place in Japan. Second, it makes products meant for export more expensive. Cars, electronics, and machinery all became relatively more costly to non-Japanese buyers. While the impact on energy sourcing from the natural disaster in 2011 was a contributing factor, Japan’s balance of payments went negative for the first time since 1980. Japan’s economy, already in a weakened state, was getting worse.
No central bank will admit to using policy to manage their country’s currency. The Bank of Japan has described the actions taken as a way to impact the Japanese economy, not as one to weaken the Yen. However, in a world where the scarce commodity is demand, currency becomes a critical variable for growth. Virtually all the developed economies have struggled to produce growth in the post financial crisis world. A combination of household demand suppressed by still high levels of debt and sluggish employment metrics, governments that have begun to either withdraw fiscal stimulus made available during the financial crisis or those who must do so to receive support from the ECB or International Monetary Fund (IMF), and corporations who in reaction to the reduced demand have been reluctant to invest capital, has kept global demand well below trend. One avenue that is left is the chance to sell one’s own goods to a foreigner, and a quick way to improve or destroy competitiveness is through currency. The appreciation of the Yen over the years relative to Japan’s principal trading partners had left them in a difficult position, one that had to be addressed to revive growth.
Now that Japan has joined other major developed market central banks in creating money to depreciate its currency, what impact will that have on other markets and inflation?
To the extent that Japan is successful in stimulating growth through the devalued Yen, we would think that the ECB would be the next central bank to engage in quantitative easing and money creation. To date, while the Euro has fallen from pre-financial crisis levels, it remains surprisingly strong given the series of crises, Cyprus being only the most recent, that have plagued the Continent. Europe is in recession and needs a source of growth. It seems only a matter of time before the ECB moves from rhetoric to actions that will reduce the value of the Euro.
According to Milton Friedman, inflation is always a monetary phenomenon. His license plate had the equation MV=PQ, money times velocity equals price times quantity. In a world where most of the central banks are creating significant amounts of money, where is the inflation? One of the explanations is that we are in a world of lazy money. Lazy in the sense that the velocity of money, the number of times a dollar is used in the economy, has fallen. Velocity is defined a number of ways, but solving the equation, it is economic activity divided by money supply. If money supply is rising and prices are not, then either we have too much quantity or money is not moving very quickly. We see this laziness of money as reflected in weak loan demand and large deposit balances at banks. Unless and until we see loan demand increasing, inflation is unlikely to be created from central bank activity.
Japan has joined the other developed market central banks in creating money and adjusting its currency value. We see this as necessary for Japan and likely to create a response from Europe. The fear that such monetary policies will of themselves create inflation is unlikely in a world lacking demand, and investments that depend on inflation should be expected to underperform.
by Willard N. Woolbert
Mr.Woolbert is Senior Vice President and Chief Investment Officer at Pennsylvania Trust.