Bernanke on the Bank of Japan
By Scott Sumner
Here’s Ben Bernanke on the recent moves by the Bank of Japan:
The most surprising, and interesting, part of the announcement was the decision to target the ten-year JGB yield. As I noted in a previous piece on targeting longer-term rates, there is a U.S. precedent for the BOJ’s new strategy: The Federal Reserve targeted long-term yields during and immediately after World War II, in an effort to hold down the costs of war finance.
Targeting a long-term yield is closely related to quantitative easing. In a quantitative easing program, the central bank specifies the quantity of financial assets (such as government bonds) that it plans to buy, leaving the price of those assets (the yield, in the case of bonds) to be set in the market. Pegging a long-term yield, as the BOJ now plans to do, amounts to setting a target price rather than a target quantity. The central bank posts the price at which it stands ready to buy or sell bonds, but the quantity actually purchased depends on how much market participants offer to sell at that price.
In that regard, it was puzzling that the BOJ retained its 80-trillion-yen quantity target for JGB purchases; one of these two targets is redundant. I presume that the BOJ was concerned that dropping the quantity target would lead market participants to infer (incorrectly) that the Bank was scaling back its program of monetary easing. Over time, assuming that the BOJ does adhere to its new rate peg, the redundant quantity target is likely to become softer and to recede in importance. The BOJ’s communication will accordingly begin to emphasize the yield on JGBs, rather than the quantity of bonds in the BOJ’s portfolio, as the better indicator of the degree of monetary policy ease.
Technically, Bernanke is correct; if you target a price then the money supply becomes endogenous. But I believe this misses the bigger picture. If the BOJ wants to reflate the Japanese economy, then it makes more sense to “cap” rather than “peg” the 10-year bond yield. Indeed the Financial Times initially reported the new policy as a “cap”, although Japanese commenters tell me that it is actually a peg. Time will tell, and I’m a bit dubious of the claim that the BOJ will not allow negative rates on the 10-year bond.
Why is this distinction important? Return to the recent boom in “NeoFisherian” macro—the view that a policy of very low interest rates is disinflationary, exactly the opposite of the Keynesian view. I’ve argued that both sides are wrong; whether low rates are inflationary or disinflationary depends entirely on whether they are implemented by an expansionary monetary policy or a contractionary monetary policy.
Using the M*V=P*Y framework, a fall in interest rates is deflationary, holding M constant, as it tends to reduce velocity. The Keynesian argument against NeoFisherianism is that central banks create lower rates by increasing M, and that the combined effect of more M and less V is more M*V.
I think the Keynesians are right on that narrow point, but only if the low rates are indeed created by more M. Bernanke is suggesting that M could be taken out of the equation, and low rates would still be expansionary. But that’s making the opposite mistake that the NeoFisherians are making. It ignores the fact that low rates can also be produced by a contractionary monetary policy. Indeed the BOJ has been doing exactly that since the mid-1990s. So a promise by the BOJ of near-zero rates for as far as the eye can see could just as well be interpreted by the markets as “more of the same deflationary policy that we’ve been getting since 1993”. That’s how I’d interpret it if I were Japanese.
This conundrum can be avoided if the BOJ were to switch to a less ambiguous indicator than interest rates. Thus they could peg the yen at 130 to the dollar. This would dramatically boost inflation expectations in Japan. Or they could peg the price of CPI futures contracts. Or they could even use the price of gold as a policy instrument, as FDR did in 1933 (not recommended). In each of those cases the money supply is endogenous, but at least the variable being pegged would provide a clear signal of policy. Unfortunately, nominal interest rates are about the worst possible variable for the central bank to peg–hence markets did not find the recent BOJ move to be credible.
In the end, the NeoFisherians are wrong for the mirror image of the reason that the Keynesians are wrong. Nonetheless, they’ve done a valuable service by lifting up the rock, and showing all the ugly grubs and worms underneath, undermining the foundation of modern macroeconomics.
That’s sort of how I feel about Paul Romer’s new paper. He’s wrong in trying to pin most of the blame on people like Lucas, but is absolutely correct in trying to expose the rot at the heart of modern macro.
It’s the identification problem, stupid.