Fed Watch: Japan Again?

Tim Duy states the differences between Japan in the 1990s and the US today and what that means for monetary policy, and he follows up on earlier comments on Fed independence:

Japan Again?, by Tim Duy: I understand the temptation to compare the current US situation to that of Japan in the 1990’s, as the combination of equity and property bubbles appears eerily familiar. Indeed, I would not disparage anyone who drew that analogy. I think, however, there are some critical differences between there and then and here and now:

1. Japan’s banking sector recapitalized only reluctantly.  There was resistance to writing down non-performing assets and courting foreign stakeholders.  Currently, US banks are aggressively writing down bad assets and will take money from anyone in an effort to maintain capital to asset ratios.
2. The Bank of Japan moved cautiously to stem the damage from the burst bubble.  The US Federal Reserve, in contrast, has moved very aggressively.
3. Japan faced the classic Keynesian problem, a high propensity to save coupled with insufficient domestic investment to utilize that saving. These dynamics were partly the result of a challenging aging profile. Demand was simply insufficient to meet the productive capabilities of the nation.
4. Remember that Japan always maintained a current account surplus, which, of course, follows from point three above. Japan relied on the rest of the world to purchase its excess production. The US does the opposite, relies on the rest of the world to support it excess consumption.
5. Excess internal savings gave the Japanese government more than enough room to pursue aggressive fiscal policy without relying on capital inflows from the rest of the world. The US is the opposite; our fiscal policy is entirely dependent on the willingness of foreign central banks to accumulate US Treasuries.
6. China and India lacked the economic power to drive global commodity prices.

The upshot is that Japan was not facing an adjustment in its external accounts like the US. US policy is focused on maintaining domestic consumption well above domestic production, resisting adjustment in the external accounts. By my reckoning, the appropriate analogy is not Japan, but Thailand. The difference, of course, is that the Federal Reserve expects the rest of the world’s central banks to support the US via asset purchases, whereas the Fed would be unhappy offering the same support to emerging markets.

As I have said multiple times, however, this is one theory. And the safe bet given the history of the past 25 years is to expect that a deceleration of the US economy will ease any residual inflation pressures. This forecast is what gives the Fed room to continue easing.

On the pessimist side, note that the low inflation scenario relies on the assumption that monetary policy, over the medium term, will continue to have price stability as an important focus. That assumption, I believe, is increasingly dangerous. I think that we are witnessing a potential reversal of the central bank independence in this nation. Fed independence depends upon the institution’s willingness to execute its responsibilities. By failing to live up to its regulative responsibilities, the Fed opened the door to a loss of independence. And Fed Chairman Ben Bernanke lacks the political capital of his predecessor to resist the shifting currents. I hope I am wrong, but at the moment, it appears that Senators Reid and Dodd own the Federal Reserve. From Bloomberg:

The Senate majority leader said Democrats won't allow President George W. Bush's nominees to fill three vacant Federal Reserve Board posts for full 14-year terms after Bush rejected a deal for temporary appointments.

''These are all nominations where we will be unable to confirm the nominees for a full term,'' Harry Reid of Nevada said in a statement. Democrats and most Americans ''don't want to ensure that the legacy of the president's bad economic policies live on for 14 years through his Fed nominees,'' he said.

The strategy is obvious. Democrats are hoping to win the White House, and see the opportunity to place three governors on the Board. I don’t expect the nominees would be hard liners like Philadelphia Fed President Charles Plosser. The general view, I suspect, will be as follows: Inflation is not a problem. It is a straw man that allows the Fed to keep the economy at an anemic pace of growth. We need to maintain low interest rates to force the economy to grow at such a pace that the employment to population ratio regains its peak. We need Fed governors who understand this.

I also suspect that there will be substantial interest in selecting a Fed Board that is willing to accommodate growing fiscal deficits. I do not believe that a Democratic White House will restore fiscal discipline. This will be a tough sell if the economy is experiencing a protracted period of weakness, especially one that weighs heavily on household spending. Moreover, there will be campaign promises to fulfill.

And if Senator McCain takes the White House, well, he has already said that he doesn’t really understand economics, and any good Republican knows that deficits don’t matter anyway. Reagan proved it.

Note also the main topic of Dallas Fed President Richard Fisher’s speech; the title is “Defending Central Bank Independence.” Listen:

It requires more than just a law bestowing independence upon a central bank for the bank to actually be independent. It also requires that it be independent in practice. By definition, for a central bank to be independent, it must possess the ability to define its policy objectives without political pressure and it must be free to use its policy instruments without constraints. This is easier said than done.

We know from our own experience at the Federal Reserve that in times of duress, Congress or the executive branch can interfere with the workings of a central bank with disastrous consequences. In the 1960s, a populist congressman from East Texas named Wright Patman, who was chairman of the House Banking Committee, launched a comprehensive review of the Federal Reserve System that exacted an enormous strain on the System’s staff and resources. Congressman Patman was convinced that, contrary to David Ricardo, “money need[ed] to be back in politics where it was in the 19th century.”[3] He wanted to legislate away the Fed’s independence and turn it into an arm of the executive branch. Patman’s investigation had reached a point where the 12 Federal Reserve regional banks and the Washington-based Board of Governors could no longer focus on economic analysis or other functions. Complying with Patman’s congressional subpoenas was keeping the Fed from doing its job.

At the same time, President Lyndon Johnson was escalating the U.S. military presence in Vietnam and spending a pretty penny to do so; federal defense expenditures rose to over 10 percent of GDP, more than double the burden of U.S. military spending today. Johnson needed to finance that spending and felt that the Federal Reserve could provide funds cheaply by keeping interest rates low. The Federal Reserve had a real dilemma. It could cut a deal with President Johnson, who, as the most powerful Texan, could call Patman off, but at the price of surrendering Fed policy independence to Johnson’s desires; or it could continue to endure the Patman investigation and risk the Fed’s charter and long-run institutional independence.

I should note that whether the then-chairman of the Fed, a very talented and honorable man named William McChesney Martin, and Johnson made a deal is a matter of speculation. Such an agreement would not have been documented if it did exist. What is known is that Chairman Martin met with Johnson at the White House in May 1964, and soon thereafter the Patman hearings unceremoniously ended without any legislation amending the Federal Reserve’s standing. The Fed held interest rates mostly unchanged over the next 19 months—until December 1965—despite mounting inflation fueled by government spending.

U.S. government budget deficits continued to grow, reaching their highest relative levels on record in the 1970s. Sadly, the Fed monetized these deficits for several years during the 1960s under Martin’s chairmanship and in the 1970s under his successors, Chairmen Arthur Burns and William Miller. By 1979, inflation had jumped to 14 percent and the prime rate reached 20 percent.

The Federal Reserve managed to regain control of the economy and its own independence under the firm leadership of Paul Volcker. But the cure for high inflation was a dose of harsh medicine. A severe recession ensued, followed by years of high unemployment and high interest rates. Monetary decisions made for short-term political gain exacted a heavy toll on the American people.

The Siren call for monetary accommodation to address political ends is universal and can seduce any leader.

Sounds like Fisher shares my concerns…..sounds like a warning. Why isn’t the financial press covering this topic?

The steepening yield curve signals a changing economic environment in the months ahead. The 10-2 spread now stands at 173bp after today’s dismal reception of a fresh batch of 30 year debt, on a day with decidedly weak economic data no less. Apparently, Treasuries are starting to look a little expensive. This suggests the market is sniffing stronger growth and higher inflation ahead or stagnant growth and higher inflation. It does not suggest to me a Japan style deflation.

Today’s Treasury action coincided with the hawkish elements of Fisher’s characteristically colorful speech:

Monetary policy acts with a lag. I liken it to a good single malt whiskey or perhaps truly great tequila: It takes time before you feel its full effect. The Fed has to be very careful now to add just the right amount of stimulus to the punchbowl without mixing in the potential to juice up inflation once the effect of the new punch kicks in. … My dissenting vote last week was simply a difference of opinion about how far and how fast we might re-spike the monetary punchbowl. Given that I had yet to see a mitigation in inflation and inflationary expectations from their current high levels, and that I believed the steps we had already taken would be helpful in mitigating the downside risk to growth once they took full effect, I simply did not feel it was the proper time to support additional monetary accommodation.

Note that like Plosser, Fisher is raising the specter of inflation to market participants who fundamentally believe that the Fed leadership, Bernanke and his Vice Chairman Donald Kohn, are too worried about other matters to care much about inflation. I have to imagine this will cause some steepening in the yield curve.

Bottom Line: Market participants no longer take hawkish speeches seriously, at least as far as near term policy is concerned. Similar speeches since last summer have been followed by repeated rate cuts. I don’t see a data flow emerging in the near term to forestall additional cuts. The safe bet is to expect inflation fears will subside, but the steepening yield curve is not consistent with a Japan-style outcome. I, however, am not willing to entirely discount a very different view, a rather unsettling view that I hope is entirely incorrect.

Comments

[ndk]

Great article, but I disagree with this conclusion:

"The steepening yield curve signals a changing economic environment in the months ahead. The 10-2 spread now stands at 173bp after today’s dismal reception of a fresh batch of 30 year debt, on a day with decidedly weak economic data no less. Apparently, Treasuries are starting to look a little expensive. This suggests the market is sniffing stronger growth and higher inflation ahead or stagnant growth and higher inflation. It does not suggest to me a Japan style deflation."

Remember that treasury prices are based on more than just inflation and growth. There's also a real rate of return involved. Why don't you think investors are demanding a higher real rate of return?

[Bruce Wilder]

Can we separate political preferences from positive economics?

Richard Fisher, the Texas plutocrat's friend, blames Nixon's inflation on Johnson and Martin. No political bias, there.

It seems to me that a higher rate of inflation is an appropriate response to circumstances, and the Fed did fail in its regulatory responsibilities, and there should be a reckoning.

The economic situation is lousy. The political question ought to be, who is it going to hurt most? I would not want Richard Fisher making that choice.

[groucho]

Concerning Martin's independence:

"he did not believe that the Fed should undertake measures that opposed the president outright, nor did he believe it was his role to give advice on policy matters under the purview of the administration. However, this did not prevent him from pushing through an increase in the discount rate in 1965 against the wishes of President Lyndon Johnson--a move that earned him a trip to the woodshed at Johnson's Texas ranch--nor did it preclude him from actively working in tandem with the Johnson Administration to pass the 1968 Tax Surcharge."

He was a major player in "the accord" that broke "the peg" with treasury. How many years before the Treasury re-capture's the FED and re-institutes "the peg"?

[groucho]

Another quote from "Chairman of the Fed: William McChesney Martin Jr. and the Creation of the American Financial System"

"In his book A History of the Federal Reserve (volume 1), Allan Meltzer argues that, at the end of the day, Martin was of the view that the Federal Reserve could not actively work against a Congress that willingly chose to finance a deficit through debt issuance. In view of the massive Treasury debt issuance that is projected to occur once the baby boomers start to retire and begin collecting on the income and health retirements currently promised to them, one wonders how future Federal Reserve policymakers will react to a similar problem--but one that is several magnitudes larger."

[reason]

And the safe bet given the history of the past 25 years is to expect that a deceleration of the US economy will ease any residual inflation pressures. This forecast is what gives the Fed room to continue easing.

I have trouble understanding this. Surely the room that the Fed has room to continue easing is the level of nominal interest rates not the rate of inflation. Deflation will push real interest rates up. But the problem with this scenario is the extent that a US recession will be reflected in an improving trade balance. If the falling dollar continues to push up commodity prices that may not happen. So stagflation may be the result.

[Mis-allocation]

TD..."Demand was simply insufficient to meet the productive capabilities of the nation."

Yes, but partly because its gov pursued a policy of promoting certain industries (a weak form of central planning). There was plenty of unmet demand for geriatric services, but resources were mis-allocated toward the favored industries. Japan simply didn't need any more small cars and such.

[Methodology Changes]

"By 1979, inflation had jumped to 14 percent..."

This is comparing apples with oranges. Using the CPI methodology extant in 1979, inflation today would be measured at over 10%. Using today's methodology, the 1979 inflation number would be far less. To compare inflation rates over time, the same methodology would have to be used. Either adjust past rates according to today's formula, or vice versa.

[spencer]

Thanks -- good summary of major difference between the US and Japan.

But not enough to keep me from worrying about the US entering an extended era of stagnation.

I'm still not as worried about inflation as you, largely because I do not see the pressure on unit labor cost that we had in the 1970s.

[groucho]

Bloomberg on Japan:

" Average wages slid 0.7 percent to 330,212 yen ($3,090) in 2007, the biggest drop in three years. Salaries are about 11 percent lower than they were a decade ago.

The number of part-time workers increased 4 percent last year, indicating companies are trying to cut costs by hiring cheaper labor, Ando said"

It's amazing that Henry Ford's common sense observation that you must allow the productivity of an economy to flow through to labor income has been long forgotten.

The US is in far worse shape than Japan because the US has used "consumption credit" to drive cash-flow to a much larger degree than Japan ever did.

[yamada]

Mr Duy,

Concerning your post of the differences between Japan and US,

1 2 affirmative. On the contrary, Federal Reserve Bank is too rapid in reacting to the market, urged by market. This means at the same time Federal Reserve Bank is too rapid to lose rooms for future rate cut.
3 4 5 affirmative. Japanese Government Bond(JGB) was purchased by those who shifted from savings and by banks backed by savings. The fund made by JGB was used to infuse capital to the banks to maintain capital-to-asset ratio and publicly expended for infrastructure as fiscal policy.
And that Japan was not facing an adjustment in its external accounts like the US - affirmative.

Surely macroeconomically there is differences between Japan and US.
We must focus much more on the balance sheet of each economic units, which asset section is depreciated from bust of bubble, on the other hand debt section is unchanged and become insolvent. Because each economic unit acts on it's current and expected future balance sheet, we must find the measures to reform each balance sheet, under credit crunch, which nobody has ever discovered. In this sense the situation of Japan and US is similar.

[hari]

It seems to me Fed has more or less lost its independence and become a "safety net" of last resort for WallStreet.
Latest political development is Demos will not allow GWB to fill the empty seats on Fed - until after the elction of a Demo Pres!

What if...and that's a not too dissparate an argument ...MacCain finally enters the WH?

Paul is right that this cycle the downside may be more negative than the last two...and may reflect Nixon's time.

The moral of the story is simply you can't live on borrowed money indefinitely...without ultimately paying a price for Feds mismanagement.

[Short Term versus Long Term]

TD..."The safe bet is to expect inflation fears will subside, but the steepening yield curve is not consistent with a Japan-style outcome. I, however, am not willing to entirely discount a very different view, a rather unsettling view that I hope is entirely incorrect."

Short term, slowing growth may indeed moderate inflationary pressures (especially commodities). Long term, the gov will not be able to raise enough resources via taxation of the rich to meet the promises it has made. To meet even a fraction of those promises, it will be necessary to borrow production from foreign nations, or reallocate resources domestically via inflation (reduce the standard of living of the inflation vulnerable). Those first in line to receive the newly created money will have more purchasing power (primarily gov and other subsidized borrowers), and everyone else will have proportionately less. If inflation gets high enough, everyone will have less, as the market will lose confidence in price changes to signal demand.

If an efficient business model is found to replace the current system of chaotically regulated de jure monopolies in crucial sectors, increased efficiency in these sectors may moderate the need to reallocate so many resources to them. None of the current proposals address the mandated inefficient business models. Therefore, it seems likely that radical change is unlikely until it is absolutely forced on the nation by lack of any more resources to reallocate to them. This could take decades, followed by a steep learning curve for the new systems.

[calmo]

Izit some of us are more national than others?Therefore, it seems likely that radical change is unlikely until it is absolutely forced on the nation by lack of any more resources to reallocate to them.Consider the transnationals (like Paulson, but also those more modest shareholders in companies like GM whose profit centers have moved offshore) [No really, consider those members of Congress/Senate --esp those clappers at the SOTUA, and their thunderous approval of our troops...and not their children, in some national pursuit of freedom.. strategic reserves.. wealth backed by military enforcement.
Like the cannon on the trading ships with those tricky endogenous people...this was "free" trade or else.

[Spectator]

One can always find differences with Japan, so more important are the similarities we can expect: ZIRP, bad assets on the books, wasteful spending (infrastructure too), a moribund local economy, and the dollar carry trade. That last of which will ensure high inflation and a poorer population here.

But optimists are the ones that make money. I'm optimistic there's money to be made in emerging markets with the cheap money generated by the panderers in charge here. And gold should get you plenty of gains too.

[paine]

fed up with the fed???

that venal creature of congress

lets abolish it

then we'll really see
how independently it can act

[paine]

jobster bogster aleart #1279

never trust folks
talking on the internet
about
" the carry trade"

they're about to pick your pocket

[paine]

a pearl of a passage

"Because each economic unit acts on it's current and expected future balance sheet, we must find the measures to reform each balance sheet, under credit crunch, which nobody has ever discovered. In this sense the situation of Japan and US is similar."

coase hedge rows
made of nothing but ink

comes in red and black of course

but just ink

and yet
the cascade of misery will be real enough

we gotta be able to build
a better system then this

[paine]

our generous kind and modest hostess
if i'm not mistaken
supports an independent fed

a whole generation or three
of american economists
have dedicted their careers
to the fight against inflation
some trying to minimize
collateral "real " damage
others ...less so

it reminds me of the kold warriors
how many know look back and say

"what in hell was i all steamed up about"

[paine]

mark
"hostess"

my my
seems the old unconcious scribe
changed your birth gender
why ??
damned if i know
probably too deep a cause to reach

[lonesome moderate]

Methodology Changes:"By 1979, inflation had jumped to 14 percent..."

This is comparing apples with oranges. Using the CPI methodology extant in 1979, inflation today would be measured at over 10%. Using today's methodology, the 1979 inflation number would be far less. To compare inflation rates over time, the same methodology would have to be used. Either adjust past rates according to today's formula, or vice versa.

I'm curious--what is the basis/source for this claim? I know the methodology has changed a lot, but so far as I know the changes are generally legitimate.

[Methodology Changes]

The changes may be legitimate, but they are still changes. A constant methodology would be necessary to keep track of inflation over time. John Williams web site is one place to begin your research on the topic:

http://www.shadowstats.com/

[gordon]

Tim Duy has a far greater ability to make an argument involving lots of variables than I have. What a performance - so many balls in the air at once! But I'm surprised that he decided not to use the Plaza Accord and Louvre Accord balls in his act - it seems to me that they are pretty relevant. The Plaza Accord allowed the US dollar to fall against the Yen and the Deutschmark, but according to the linked articles, the effective revaluation of the Yen certainly didn't help Japanese exports and didn't help US exports to Japan either. From the Plaza Accord article: "The recessionary effects of the strengthened yen in Japan's export-dependent economy created an incentive for the expansionary monetary policies that led to the Japanese asset price bubble of the late 1980s". I seem to remember that the Japanese later attempted massive fiscal measures to break out of their post-bubble doldrums - to little effect.

Maybe the US and Japan got into low-growth scenarios by somewhat different routes, but the Japanese experience shows that loose monetary policy in a recession may create bubbles, and recovering from a burst bubble using fiscal measures may not be effective. An as I have commented before, the effects of all this on social structure may not be good.

[Jan Paul]

Regarding inflation, Shadow stats has it pegged about 3-4% higher using constant methodology. Here is a site that has some of the changes that impact it and lower wage earners so much in buying power if wage increases are tied to it.
Grandfather Inflation report

For social security checks, I have read they would have to be 50% higher than they are to have the same buying power as 20 years ago.

By under reporting inflation, entitlements tied to COLA increase are kept from increasing as fast. Also, wages are kept lower that are indexed to inflation.

By the way, here is how debt has progressed since 1980
quote:
Household debt service payments and financial obligations as a percentage of disposable personal income; seasonally adjusted
Quarter
Total

80q4----13.33
81q4----13.46
82q4----13.82
83q4----13.71
84q4----13.96
85q4----14.93
86q4----15.47
87q4----15.28
88q4----15.05
89q4----15.51
90q4----15.5
91q4----15.18
92q4----14.28
93q4----14.23
94q4----14.54
95q4----15.18
96q4----15.46
97q4----15.49
98q4----15.19
99q4----15.48
00q4----15.78
01q4----16.38
02q4----16.82
03q4----16.92
04q4----17.01
05q4----17.7
06q4----18.22
07q3----18.03
=================================
That means that 18% is going basically for interest if that is new loans as many are among younger workers. We are paying more and more in interest and demanding, as a result, more and more help from government. 52% of Americans now get some type of government funding (governments spending is 44% of national income). Grants, social security, government contracts, subsidies, government jobs, Welfare, etc.

The consumer is not only getting tapped out but so are cities and states now that tax revenues from the housing collapse are falling like rocks.

I look for massive federal spending programs on infrastructure to soon be announced, especially on the Five Corridors and highways in NAFTA plans. I recently took pictures of the NAFTA Hoover Dam bypass construction and look for many more NAFTA projects that would go for years to spur jobs and the economy. The problem will be that if consumers start saving and paying off debt instead of saving the stimulus won't work or will only delay the crisis and make it worse when it does hit.

[groucho]

Regarding Japan's "lost decade", the best read I've had is "balance sheet recession" by Richard Koo.

The US situation is similar except the bad debt is mainly a burden on the household sector. Npl's in the US are consumption credit based. Defaults and write downs with a huge govt sponsored infrastructure development program(jobs program) will be the likely outcome in the US.

"the fall in assets prices led to what is known as a “balance sheet recession”—a term he attributes to his former New York Federal Reserve colleague, Edward Frydl. Balance sheet problems caused Japanese companies to move away from “profit maximization” to “debt minimization.” This absorption of free cash flow (FCF) to pay down principal on interest-bearing debt predominately explained (and explains) the fall in aggregate demand as investment in new businesses became a secondary issue. As aggregate demand waned, so did the need to borrow from banks (hence, the low interest rates) and the weak deflationary economy. Thus, the weak economy forced asset prices to fall further, leading to more corporate bankruptcies and a BoJ dramatically easing its monetary policy. With more corporate bankruptcies and low interest rates, banks suffered ever-increasing non-performing loans (NPLs)."

[Methodology Changes]

Jan Paul..."Regarding inflation, Shadow stats has it pegged about 3-4% higher using constant methodology."

The chart is pre-Boskin, but post 1980 methodology. There have been 2 major revisions. The 1980 to Boskin methodology calculates the rate at 3-4% higher, and the pre 1980 methodology would calculate the rate at over 10%. An example of the changes: At one time, home prices were included in the index, but were replaced by estimated rents. You can't directly compare an index that includes home price increases with one that substitutes rent increases, because they increase at dramatically different rates. Housing is a very large percentage of the index, so the total difference between the two methodologies is large. I was not commenting on which methodology is better, just pointing out that they do not measure the same thing.

Jan Paul..."By under reporting inflation, entitlements tied to COLA increase are kept from increasing as fast. Also, wages are kept lower that are indexed to inflation."

Experience has shown that inflation only decreases the unemployment rate long term if the rate of inflation stays above both wage growth and inflationary expectations. Since the Fed has a mandate to minimize unemployment. Consider that a CPI methodology that results in a gradually declining living standard for the same CPI adjusted wage would allow a constant inflation policy to accomplish the mandate. Thus, a subtle conflict of interest is created.

Now consider, the CPI adjusted median wage is higher than it was a few decades ago. A few decades ago one median wage could comfortably support a household. This is no longer the case. Households now need 2 median wage incomes, plus overtime on top of them, to comfortably support a household. Do you see the pattern?

[paine]

"Why don't you think investors are demanding a higher real rate of return"

priceless personification of the market
deeply consider the irony and folly of this query

[groucho]

"Why don't you think investors are demanding a higher real rate of return"

Unless you're planning on "marrying" an asset risk adjusted capital gain is the game mixed with flight to safety capital preservation game.

Bernanke's continued chopping is an attempt to put a floor under risk assets.

[Jan Paul]

I agree with "Methodology Changes." I was being "generous" with the 4%. It is much worse and most stats from the Government are much worse that reported.

Today, in an article, the author said the 4 decade consumer binge is coming to an end. That means a long "recovery." Another article is calling for lower stock prices for 5 years. Some say a better 2nd half to this year and then the hammer falls. Others say it is now. But, more and more are saying "this time is different" in that we can't "fix it" with rate cuts and stimulus spending. Maybe a delay, but, then an even worse crisis if we do delay it.

The issue of "housing" in inflation reporting is spot on and "Methodology Changes," has it correct. There has been so much game playing, it is unreal.