With all of the news out of Europe and US equities reaching all-time highs, one headline has quietly passed under the radar, but may be just as important as Cyprus or the Dow. The Bank of Japan (BOJ) last week approved one of the largest stimulus plans in modern history, one which would nearly double Japan’s monetary base.
Reuters reports that the BOJ has been committed to buying assets in the open market in an effort to pump ¥130 trillion ($1.4 trillion) into the economy. In doing so, the BOJ has become one of the only central banks in modern history to target primarily the monetary base and abandon interest rate structuring. The overall goal for Japan’s economy is to achieve 2% inflation in a matter of 2 years.
Many readers will not truly be able to grasp that move; not that they do not understand basic economics, but do not understand why a country would take such a bold risk and WANT inflation. It is important that we take a look at Japan’s recent economic history to truly understand their priorities.
Throughout the 1970’s and 1980’s Japan’s economy was booming, much of which can be credited to the Japanese government investing in their domestic economy as well as aid from some foreign nations. However, Japan’s economy grew too strong too fast, and ever since the early 90’s Japan has had a deflation problem.
Opposite to inflation, deflation occurs when a domestic economy becomes so relatively strong that goods are often produced at a higher price than what they can be sold at. Deflation typically also results in cash hoarding, as investors feel that the currency will continue to grow stronger, which stifles economic growth. As painful as inflation can be, deflation can ruin an economy. For a healthy economy, GDP growth rate and inflation should run at a similar rate, the reason being that if inflation gets out of hand a country becomes less attractive and less competitive to foreign investors and foreign producers of goods. Likewise if the GDP growth rate runs higher than the inflation rate and the monetary base cannot keep up with economic expansion, we enter a deflationary environment.
Beginning in the mid 1990’s, Japan’s inflation rate began to plummet and the exchange rate with the US showed the impacts. In 1990, $1 would buy you almost ¥160, while today $1 will buy you less than ¥100. Since 1990, Japan’s GDP growth has remained relatively stagnant.
The overall hope of the BOJ is that by pumping new cash into the system and keeping interest rates low that they can spur economic growth, which will in turn raise their GDP, all while doubling the monetary base which will provide them with inflation necessary to compliment their hopefully stronger economy. Remember our old inflation equation: volume*velocity = inflation. Japan hopes that low interest rates will raise velocity and buying assets in the open market will raise volume.
While Japanese equities markets liked the news, the Yen fell against the USD the week that the program was announced.
If we view the US economy in a vacuum, we do not really get a clear picture of what is going on around us, only what is happening in our own environment. It is important to take note of situations like Japan’s and see how they apply to the US and our economic woes, as well as what they mean for global investment, and if they open up any opportunities for the US economy to grow. However, what works for one country does not always work for another, and only time will tell if Japan’s bold plan pays off.