Today I want to talk about one of the real tragedies of monetary policy and inflation: Japan.

The tragedy is that the mystery of the deflation in Japan is no mystery at all. The cure also was no mystery. So the tragedy is that these were both treated as mysteries by the central bank, which stumbled on the right response and then stumbled right back out of it again.

The chart below shows the money supply and core inflation history of Japan going back into the 1990s. Core inflation is in red (I’ve interpolated through the sales-tax-induced spike) and M2 growth is in blue. The cause of the disinflation is pretty plain: between 1998 and 2013, year/year money growth in Japan never exceeded 4%. From 1999 to 2013, Japanese M2 rose 38% in aggregate; in the US it rose 138% over the same period. It is very hard to get inflation, especially in an environment of declining interest rates, if the money supply is increasing at or somewhat less than the rate of potential GDP growth.

(Click on image to enlarge)

However, in the middle of 2013 Japanese Prime Minister Shinzo Abe persuaded Bank of Japan governor Haruhiko Kuroda to promise to double the money supply in two years, by pursuing massive QE. Although that turned out to be an exaggeration, M2 growth did peek out from behind 4%, and inflation started to perk up as well. It wasn’t a lot, but inflation in 2013 reached new 14-year highs and the economy was officially out of deflation. While QE made very little sense, at least the QE2 and later versions, in the US where inflation was positive and money growth was adequate, it made a ton of sense in Japan. In fact, if Japan had been the only country pursuing QE, I can make the argument that the yen would have likely depreciated substantially and caused inflation in that country.

In the US, the central bank pursued QE and risked inflation to hopefully spur GDP growth. But in Japan, both of those were desirable outcome. There was no reason not to pursue QE in Japan.

But the Bank of Japan lost faith in the power of money growth to cause inflation. While the BoJ continued asset purchases, those purchases diminished and the rate of increase in the central bank’s balance sheet declined from roughly 50% y/y in 2014 to around 8% today (see Chart, source Bloomberg).

(Click on image to enlarge)

Instead, the Bank decided to deploy negative interest rates, dropping the policy rate to -0.10% from +0.10% in early 2016. They did this partly because it was a central bank fad in 2015 and 2016 to experiment with negative interest rates, despite the fact that we have no idea (and no guidance from theory) about what happens to monetary velocity at negative interest rates. I wrote the following in our quarterly piece on February 20, 2016 (and I think it’s been long enough that it’s fair to put it in the public domain as our customers have had plenty of time to read it in private!). I quote at length because, frankly, it was pretty good:

 “…the question of what happens to monetary velocity at negative interest rates is one worth considering since several central banks (the latest one being the Bank of Japan) are now implementing monetary policy with a negative policy rate.

“Why the Bank of Japan is doing so is beyond us. Abstracting from the sales-tax related hike, it has successfully eliminated deflation, driving core inflation from -1.5% to near +1.0% since mid-2010. It has done so, very simply, by working to accelerate money supply growth from the 1.5%-2.0% growth that was the standard in the late pre-crisis period to over 4% by 2014 and 2015.

“This isn’t rocket science; it’s monetary science.

“Now, recently money supply growth has begun to fall off, so the BoJ likely was concerned by that development and wanted to find a way to ensure that inflation doesn’t slip back. If that was their intention, then cutting rates was probably the wrong thing to do. As Friedman explained decades ago, and we have illustrated here repeatedly, money velocity is strongly tied to the level of interest rates. Lower interest rates imply less reason to not hold cash; ergo real cash balances rise and the inverse of the demand for real cash balances is velocity.

“But we said “probably” the wrong thing to do for one reason: we don’t really know whether this relationship holds when interest rates cross the negative bound. It maybe the case that this relationship ceases to apply at negative rates even though Friedman’s idea is based on the relative difference between cash yielding zero and longer-term investments or consumption alternatives. The reason that velocity might behave differently at sub-zero rates is that people respond asymmetrically to losses and gains. That is, the pleasure of a gain is dominated by the pain of the same-sized loss, in most people. This cognitive bias may cause savers/investors to behave strikingly different if they are charged for deposits than if they are merely paid zero on those deposits (even if zero is lower than other available rates). In that case, we might see a spike in money velocity once rates go through zero as cash balances become hot-potatoes, just as they would if investment opportunities suddenly appeared. Now, we need to make several observations.

“First, there is no data to suggest this effect exists. What we have posited in the preceding paragraph is rank speculation. (But, unlike the various central banks, we’re not betting our entire monetary policy on that speculation).

“Second, while we don’t really think this effect exists, if it does exist then we would expect it to be a spot discontinuity in the relationship between rates and velocity. That is, the behavior should change between 0% and some negative rate, but then be somewhat linear thereafter. Cognitively, the reaction is both a general loss aversion, which is linear but no different at negative rates from zero, and a behavioral “endowment” reaction that is to the “taking” of money from a person and not necessarily related to the size of the theft.

“Third, if this effect does exist it still doesn’t mean that cutting rates to a negative rate was wise for the Bank of Japan. After all, quantitative easing has done a fine job of pushing up inflation, and so there is no reason to take a speculative gamble like this to keep inflation moving higher. Just do more of the same.

“Fourth: more likely, the BoJ is doing this because it believes that negative rates will stimulate growth. This is much more speculative than you might think, and we may be overgenerous in phrasing the point that way. In any case, any growth benefit would stem either from weakening the currency (which QE would also do, with less risk) or from provoking investment in more marginal ventures that become acceptable at lower financing rates. We call that malinvestment, and it isn’t a good thing.

“Inflation was moving higher in Japan. As long as QE continues (with, or without negative rates), then inflation should continue to move higher. But if the BoJ abandons its successful anti-deflation policy because it was not effective at increasing growth, then it is likely to end up with neither inflation nor growth.”

So, this is the tragedy. As the first chart above illustrates, increasing asset purchases seemed to increase the money supply and inflation; however, cutting interest rates had the evident effect of decreasing monetary velocity enough to push the Japanese economy back to near-deflation. It’s tragic, because they had the right policy and essentially for the right reasons, but changed it to the wrong policy for reasons that are tied to economic dogma which happens to be incorrect (that the act of lowering interest rates causes inflation).

It isn’t the only tragedy to be visited on global economies by too-smart-by-half central bankers, but it is one of the most tragic because they were on the right track before their buddies in the central bankers’ club persuaded them to change tack. It’s like the alcoholic who, having suffered into sobriety, is tempted by friends to have a ‘social drink’ and ends up back in the bottle. At this stage, there is no longer any way for this to end well.