The Bank of Japan’s announcement on March 9 that it would be exiting its regime of Quantitative Easing (QE), initiated in March 2001, was bittersweet joy for me. Not that I disagreed with the Bank of Japan’s decision at all. It was the right thing to do at the right time. I applaud!

My melancholy was driven not by the looming end of QE, but rather by my reflections on the conditions that had triggered QE in the first place: a Minsky-style debt-deflation in Japan. Such an outcome should not have unfolded. And it would not have ever unfolded, I firmly believe, if Japanese policymakers had pursued and sustained proper Keynesian reflationary policies following the collapse of equity and property bubbles in the early 1990s.

QE was the last-ditch policy to get Japan out of the debt-deflation ditch. And it worked! The mechanical details of the QE approach are fascinating, both historically and prospectively, as we try to forecast the machinations of its removal. My Tokyo-based PIMCO colleague Tomoya Masanao does a fantastic job going through these matters in a special center-section article in this edition of Fed Focus .

But you need not be an economist to grasp the essence of the approach. QE was simply a fancy way for the Bank of Japan to commit resolutely to subordinate Japan’s monetary policy to her fiscal policy, despite the Bank of Japan’s legal independence from Japan’s fiscal authority.

Effectively, the Bank of Japan promised to fund, directly and indirectly, any and all fiscal deficits and associated government debt issuance at zero short-term interest rates, including debt issued in the conduct of currency intervention designed to resist appreciation in the value of the yen. And the Bank of Japan promised to persevere in this policy until the consumer price index was sustainably rising, year on year. This was anti-deflation policy at its best. It should have been adopted many, many years before.  

From Liquidity to Reflationary Wine
Indeed, none other than Fed Chairman Bernanke would have gone even further. As detailed in a speech in Tokyo on October 24, 2003, over two years after QE was adopted, Mr. Bernanke advocated that the Bank of Japan not only stick with its anti-deflation liquidity provision but to turn it into reflationary wine. Specifically, he said (his emphasis, not mine!):

“For Japan, given the recent history of costly deflation an inflation target may not go far enough. A better strategy for Japanese monetary policy might be a publicly announced, gradually rising price-level target. What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.)  

Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises,the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap. The price-level gap is the difference between the actual price level and the price level it would have obtained if deflation had been avoided and the price stability objective achieved in the first place.  

A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation.”  

This was Gentle Ben’s real “helicopter speech,” not his famous November 21, 2002 lecture titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” In that earlier speech, Mr. Bernanke argued that the Fed both could and should prevent deflation. To be sure, he also noted, academic style, that the Fed would not be impotent to reverse deflation, if preventive measures failed.

He declared the Fed could “cure” deflation by coordinating with the fiscal authority – implementing a “broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase.” He went on to note that “a money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.”

But Mr. Bernanke was not advocating such a thing for the United States in the fall of 2002, because America was not suffering from deflation, just the remote risk of it. In contrast, in the Spring of 2003, he was advocating a “helicopter drop” of money in Japan, which had been suffering from deflation for many years.

And, in fact, QE, which was implemented two years before Mr. Bernanke spoke in Tokyo, was effectively a “helicopter drop.” Ben didn’t have a problem with it at all, but like the church choir director, he wanted it with more feeling. Specifically, he said:

“My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent. 

Under this plan, the government’s concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but – because the BOJ purchased government debt in the amount of the tax cut – no current or future debt service burden has been created to imply increased future taxes. Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices.”

Good Enough for Government Work 

In the event, Japan authorities didn’t take the full measure of Mr. Bernanke’s advice, which was in fact that the fiscal and monetary authorities explicitly and jointly conduct a “helicopter drop” of printing press money. But they implicitly did, with the helicopter directed to:

• Re-capitalizing the deflation-ravaged banking system, kicked off by the “surprise” bailout of Resona Bank in May 2003 (just as before Mr. Bernanke was there!), which presaged a full-blown fiscal bailout of the entire banking system. (Even before the bailout of Resona Bank, the BoJ made a de facto capital injection into the banking system by purchasing banks’ holding of equity portfolios in its own account.) 
• BoJ’s outright purchase of asset-backed securities up to $8 billion dollar-equivalent as a way to substitute for the not-functioning banking system and supplement the undeveloped capital market. 
• Yen sales against dollars to thwart deflationary appreciation in the Yen, which crested at over $100 billion dollar-equivalent in the first quarter of 2004. 
• Huge outright purchases of long-dated Japan Government Bonds, averaging $28 billion dollar-equivalents per quarter since April 2001.

And QE worked! Exactly how it worked is somewhat mysterious, with economists pulling out all sort of models and theories. For me, however, the most cogent thesis is also the most simple: QE was a beautiful signaling device that the fiscal and monetary authorities were, finally, willing to coordinate their polices, with the monetary authority explicitly surrendering its independence unless and until deflation was defeated.

And there was nothing wrong with the Bank of Japan doing so, even though it had only “gained” its independence from the Ministry of Finance in 1998. As Mr. Bernanke also noted in his May 31, 2003
Tokyo speech:

“The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say “no” to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty.”

Three years later, it is now time for the Bank of Japan to reassert its independence, or sovereignty. Put differently, it is time for the Bank of Japan to regain the ability to hike short-term Japanese interest rates. And as a practical matter, that means ending QE because as a mechanical matter, the Bank of Japan can’t hike rates when the banking system is floating in excess reserves, the mechanical manifestation of QE. Again, Tomoya goes through the details in his center-section essay.

The question of when to end Zero Interest Rate Policy (ZIRP) is not a technical issue, however, but a very different question, as is the even more important question of the appropriate trajectory for short-term rates after ZIRP is ended. Regaining of independence does not and should not be punctuated by an independent decision to do something stupid, just because you have the freedom to do so!

Which brings us back to the issue of what positive rate for inflation the Bank of Japan should seek. In announcing the end of QE, the Bank of Japan defined price stability as a 0%-2% range for inflation, but explicitly declared that this was a definition, not a target. And, yes, that is a difference with a distinction: targets are presumably objectives that are to be actively sought, while definitions are desirable states of the world.

Interestingly, the middle point of that range is exactly what Ben Bernanke had suggested in May 2003. I doubt that is a coincidence. What the Bank of Japan did not address when announcing the end of QE, however, is how much scope it sees for actual reflation , as Mr. Bernanke also advocated: a period of time when the actual inflation rate is above the definition of price stability, so as to recoup the “price level gap.”

As a practical matter, Bank of Japan officials probably don’t have a firm idea themselves on this issue. My gut says, however, that in the matter of goods and services inflation, more will be better, unless there is a threat of runaway asset price inflation. Bluntly put, a central bank that has committed the carnal sin of allowing outright deflation, for year after year, owes its citizenry a long period – not just a considerable period! – of contrition and forbearance of cyclically rising inflation.

Bottom Line
I anticipate that is exactly what the Bank of Japan will do, in its own independent judgment. Thus, if and when the money market forward curve in Japan goes nuts in discounting the trajectory of Bank of Japan tightening, we will want to buy it. It’s not done so yet, at least not egregiously so (see Chart on cover). But if and when it does, as the logic of reflexive, emotional market history suggests, it will be time to remember that reflation is as reflation does. And that reflation is all about low real short rates for a long time.

Or, in the words of Bank of Japan Governor Fukui on March 16:

I would now like to touch on the Bank’s thinking regarding the future path of monetary policy. There will be a period in which the un-collateralized overnight call rate is at effectively zero percent, followed by a gradual adjustment in light of developments in economic activity and prices. In this process, if the risk I have described remains muted, in other words, if it is judged that inflationary pressures are restrained as the economy follows a balanced and sustainable growth path, an accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time.

Yes, the ghost of Mr. Bernanke remains in Tokyo. And it’s named Gentle Ben, too.

Paul McCulley
Managing Director
March 31, 2006
mcculley@pimco.com