Japan is Bac… Maybe Not: Still A Long Way to Go

The late Milton Friedman once stated “monetary theory is like a Japanese garden, an apparent simplicity conceals a sophisticated reality.” Interestingly, experience of the last twenty years of Japanese economy shows us that the solving economic problems Japan has been facing requires not one-and-done expansionary monetary policy, but more sophisticated yet unfamiliar policy tools, including unconventional monetary policy, expansionary fiscal policy and structural reforms.


The period of Japanese stagnation was initiated by the falling asset prices in the early 1990s, which in turn led to large deleveraging process by households and firms . The deleveraging process further caused a decline in aggregate demand and a persistent deflationary period from the end of 1990s until recently. In addition to the aggregate demand deficiency, there is a deeper and unavoidable cause for the problem in the Japanese economic performance in the long-term: changing demography. As a big part of Japanese labor force is retiring and the fertility rate in the nation isn't high enough to keep the population growing, the labor force has not been sufficient to continue the economic growth Japan experienced during decades prior to the 1990s.


However, Japan is able to reach its current potential output through a combination of appropriate and perfectly timed fiscal and monetary policies under prime minister Shinzo Abe. The policymakers should note that expansionary monetary policy is appropriate only if there is significant under utilization of labor resources in the economy. Use of both expansionary fiscal and monetary policy even after the economy reaches its potential and shows signs of ability to maintain it without those only creates fear of repeating the mistake the BoJ made in the late 1980s to not tighten the monetary policy leading to soon-to-be burst stock market bubble. Considering the recent sluggish growth in 2014 and both medium-term and long-term economic goals of Japan, I propose that Abe’s government and the Bank of Japan continue quantitative and qualitative monetary easing (QQE) until the unemployment rate drops to and stays at the natural rate of unemployment* for a considerable amount of time and offset contractionary fiscal policies such as increasing tax and cutting government spending by further monetary policy stimulus to keep the nominal GDP growth on trend. The next blog posts will further elaborate on these proposals and more detailed policy recommendations.

When Are We Happy?

(Tune in while reading: http://www.youtube.com/watch?v=y6Sxv-sUYtM)
Every person has different answers for this simple question. But we don't know an exact answer for what makes us happy for what reasons. There are more questions that human kind has been trying to find an answer for like whether being happy is what people seek in life.

The word "happy" is itself very ambiguous. People can describe them happy in two different ways:

-depending on their mental state at the moment; reflecting short term condition

-depending on whether they are living lives they want; reflecting long term condition

Regarding the first sense of the term "happy", there have been studies and recommendations trying to find out in what condition people feel happiness. In an episode of the TED Radio Hour Show, guest speakers talked about their findings on being happy. Harvard PhD student Matt Killingsworth conducted survey based research on happiness, and his result shows that if we want to be happier, we should live at the exact current moment. In other words, according to his smart-phone app based survey, people in the study answered they are happy when their minds were focused on what they were doing at the exact moment. On the other hand, people answered that they are happy less times when their minds were on something else such as what they are going to do after they finish their current tasks. Simply put, if you want to be happier, enjoy the moment!

Also, on the same show episode, Carl Honore, an author, advises us to slow down our speed of lives to be happier. He argues that today, people speed in their most tasks, and this leads to less happiness, less productivity and less quality of life. Another speaker Graham Hill, a designer, talk about how we are happier when we have less stuff in life! More elaborately, his point is that we are happy when we have simpler stuff in life.

If we can be happier by following above advises, how can we be happier in our whole lives, in general? Even though I don't want to say this, most people feel pressure and unhappiness by choosing to compare themselves with others. We make ourselves unhappy by envying others. In other words, people choose to be less happy because of other's fortune, luck and possession. This tendency to compare ourselves with others come just naturally to us. However, people should try to control their happiness by what they possess instead of what others possess.

Also, in addition to comparing what we have with what others have, we seemingly compare what we have with what we thought what we would have. In other words, in some sense, we feel happy whenever we experience somewhat unexpected pleasure giving events. Then again even though I don't want to say this, we should lower our expectations in life to be happier. Maybe we can expect the worst and hope for the best!

Happiness has been a topic of economic researches for decades. Richard Easterlin's study on human's well being during 1970's has greatly shaped following studies by economists. His main finding, later called Easterling Paradox, was that well-being and happiness are greatly correlated with people's income, but until income reaches certain point. The latest research on happiness done by University of Michigan professor Justin Wolfers shows how economic and demographic factors play a role in being happy. Even though I don't believe the title is appropriately given, an article "Money can buy happiness, economist says" pinpoints results of his study. Here are some interesting ones:

• Men in recent decades in America are happier than women. “No one knows exactly why,” Wolfers told the audience. It may be that women have internalized several measures of success, more than the basic “am I popular” focus young women faced growing up in the 1960s, he said.

• In general, not only are the rich happier than the poor, but globally, richer nations are happier than poorer ones, Wolfers noted.

• Among Americans in the lowest 12 percent of income-earners, 21 percent said they were happy. Of those earning more than $150,000 per year (the top 10 percent), 53 percent said they were happy.

Flipping the question, among the lowest-earning 12 percent, 26 percent said they were unhappy in general, based on a set of factors such as enjoyment of meals, depression and feeling respected. Of the top 10 percent, only 2 percent reported feeling unhappy, he said.

The notion that riches are happier than poors isn't totally groundbreaking news even it wasn't true. But at the end, most of us seek to get higher salary jobs assuming that it makes us happier. Then from this study, we can advise ourselves that get rich to become happier!

Fed Officials Expect Overshooting Unemployment Rate

Following the Fed's March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are "based on FOMC participants’ individual assessments of appropriate monetary policy." Therefore, these number's aren't actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials' own appropriate policy. 

In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member's policy recommendation.

The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed's policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.

 From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials' expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.

Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn't always mean expansionary monetary policy as Milton Friedman put it, "After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."

The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.

 The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.

So, what can we conclude about the Fed's future policy from these two charts?

The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.

 As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed's target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?

Then, given the the below target inflation rate, the Fed officials shouldn't be worried about their fed funds rate target expectation below the long-run expectation.

From the Fed officials' projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy.- if we assume these projections are made with rational expectation

Fed, Raise the Inflation Target

Friday's report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed's target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its "target" for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called "target". In my Monday's post, I made a case for the second question getting an answer "yes!". If the Fed is indeed targeting inflation rate lower than its 2 percent "target", the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation "target" given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let's look at the Fed's latest statement:

"To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored."

The Fed, in my policy prescription, should change "run below the Committee's 2 percent longer-run goal" to "run below 3 percent" (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn't been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn't seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson's paper?

Sorry Krugman, It Is Not Happening (or seems to be)

In his blog post on last Friday, Paul Krugman argues that the Fed should be targeting 4 percent inflation rate, which is, according to him, the inflation rate that is needed when the economy is at the zero lower bound, instead of current inflation target of 2 percent. He argues that by targeting inflation rate which is lower than a rate needed by the economy to get boost, the Fed does nothing to raise the inflation rate, which is currently below 2 percent, because even if the market believes in the Fed's target of 2 percent inflation rate at the beginning, its inflation expectation will decrease as time goes and actual inflation will be back at the low level. But, according to him, if the Fed explicitly targets 4 percent inflation rate, assuming 4 percent inflation is the right amount to boost the economy, this will give boost to the economy and hence drives the inflation up. However, the Fed is not even considering to target above 2 percent inflation rate as opposed to Krugman's inflation target of somewhere around 4 percent. We can see an evidence for the Fed being dovish.

In the Fed's recent statement, it dropped infamous 6.5 percent unemployment threshold for raising short-term interest rate. Known as the Evans rule, the Fed's former quantitative forward guidance statement was giving timeline for raising interest rate closely tied to the unemployment rate. As we know, once the unemployment rate unexpectedly (for the Fed) dropped to 6.6 percent in last month, it had to change its forward guidance program because if it had continued mentioning 6.5 percent threshold, and once the unemployment rate had reached the threshold, the Fed could have then made market expectation of increasing short-term interest rate when the economy needed the opposite. To avoid this unexpected mistake, they dropped the quantitative threshold for raising the interest rate.

The Fed undoubtedly has learned its lesson: Never underestimate the economy or should I say power of some number like 6.5? Having experienced the problem of changing the forward guidance appropriately, the Fed must have now issued their statement with great care of not choosing any random numerical threshold. But guess what? The Fed's statement still includes the inflation target of 2 percent. The Fed's latest statement reads:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Let's now imagine that somehow the inflation rate reaches around 1.9 percent in one of the coming months and assume the economy will not have gotten out of the recession slack (which is very likely), the Fed now faces the same problem it faced two months ago when the unemployment rate almost hit 6.5 percent threshold, but, in this case, only the inflation rate almost hits the target of 2 percent. Should then the Fed increase the federal funds rate according to its statement inferred if the inflation rate reaches 2 percent target? or should the Fed change its forward guidance again and drop the inflation rate target as it did unemployment rate threshold? Interestingly, the Fed will do neither of them because:

First, they learned its lesson of changing the guidance prematurely. Second, and more importantly, they KNOW that they will never face the inflation rate close to 2 percent during the recovery; hence, they won't have to do either of above.

In other words, from the Fed's current statement and its current mistake, we can almost be sure that it will never target the inflation rate above 2 percent as long as the economy is still recovering. Two percent inflation target is then an upper bound for the inflation rate the Fed targets.

Some people has argued even that the upper limit of 2 percent for the inflation target is indeed what the Fed has been pursuing for these years.

Therefore, it seems unlikely that Krugman will see whether 4 percent inflation target could get the economy back to work. Sorry Krugman, it is not happening (or seems to be).

Economic History: Panic of 1896

In my blog posts, I have been trying to write multiple type of posts, such as posts on someone's paper, someone's article, or the WSJ articles. This time, I wanted to do little bit of research on economic history.

The Panic of 1896 is one of the pre-World War I economic contractions that was caused by the gold standard of the late 19th century and declining world price in terms of gold. The panic, according to the NBER business cycles dates, dated from December of 1895 to June of 1897. During the panic, the business activity declined by 25.2% and the unemployment rate increased from 13.7% in 1895 to persisting 14.5 % in 1896 and 1897 following a decrease in unemployment rate from 18.4% in 1894 (Romer, 58). At the beginning of the contraction and the end of brief recovery from the Panic of 1893, the aggregate output of the economy hadn't reached the peak of the previous business cycle; therefore, the Panic of 1896 is often considered as a continuation of the Panic of 1893. The Panic of 1896 was caused by a huge
drop in the Treasury’s gold reserve because of the public suspicion for departure from gold standard, whereas the Panic of 1893 was caused by bank runs due to concern over the solvency of the banks.

Cause of the Panic

Deflationary period

The panic relates to the US business cycle contraction defined by NBER as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

A slowing of the rate of increase of the world’s stock of gold, an increase in the number of countries on the gold standard and a higher growth rate of the total economic output resulted in a deflationary period from 1875 to 1896 with a rate of 1.7% a year in the US (Friedman, 69). The US money stock increased only 6 percent from 1891 to 1896. In meantime, the nominal net national product decreased by 1 percent per year on average, whereas the real net national product increased by 2 percent per year (Friedman and Schwartz, 97). The rate of growth of the real output, which was greater than that of growth of the money supply during this period, put pressure on nominal price.

Prior to 1873, the US was under bimetallistic standard. The Coinage Act of 1873 essentially demonetized silver by omitting the silver dollar of 371.35 troy grains of pure silver, and the Resumption Act of 1875 further established the gold standard. During this deflationary period, political movements for free silver coin and departure from the gold standard in the
US were increasing as the United States needed an increase in the money stock to stop the deflation. Farmers, being unable to pay their debts with lower prices, and silver producers, who was hit by lower silver price, formed the People’s party and The National Silver party.As the gold reserve in the Treasury dropped to $45 million in January of 1895, the public’s worry for the maintenance of the gold standard, which was proximately originated by the Sherman Silver Purchase Act of 1890, put more pressure on gold reserves.

Election of 1896

In July of 1986, William Jennings Bryan’s nomination from the Democratic Party for the 1896 presidential election further intensified the pro-silver movement because of his platform for “free silver.” Hoping he would win the election, the People’s party and the National Silver party also nominated him for the election. After his nomination, the demand for foreign exchange increased as the dollar holders wanted to convert their dollar to the currencies that were backed by gold. To do so, dollar holders demanded to convert their dollars to gold first by putting more pressure on gold reserves. In other words, the election accelerated net gold outflows (Friedman and Schwartz, 112).

Another view on the cause of the panic is cotton harvest fluctuations due to exogenous variables, such as weather (Hanes and Rhode). Among the main three crops, wheat, corn and cotton, the cotton production fluctuation was the only one to affect the industrial production of post bellum period (Hanes and Rhode). Way the cotton harvest affected the downturn of the business cycle was through the decrease in the reserves in banks and stock price decline. The poor cotton harvest year in 1896 caused a decrease in cotton export and the decline in gold inflow. The cotton export revenue accounted for 25% of the total merchandise export revenue from 1880-1913 (Hanes and Rhode), so a fluctuation in the cotton harvest was one of the factors that could change the business cycle.

The way out of the panic

To stop the gold outflows, a group of gold-shipping and foreign exchange houses agreed to block the outflows. The group borrowed funds in foreign currencies from abroad and exchanged it with the American investors wanting foreign currency and foreigners holding dollars. By doing so, people transferred their dollars into other currencies without first converting them to the gold; therefore, the decline in gold reserves was managed.

When the harvest time came at the end of the August of 1896, crop
export season started and gold inflow started to increase. The victory of the
Republican Party in the presidential election eased the public’s worry about
the US’s departure from the gold standard.

The Fed Ties Interest Rate Raise (*remotely) to the Tapering Instead of Unemployment Rate

Following today's Fed's meeting, the meeting statement has been scrutinized by every word to word. Of course, the biggest headline news was the Fed's move to drop the unemployment rate of 6.5% as a threshold rate for raising interest rate from its meeting statement. Not only are Fed watchers reading the statement literally word to word, but also some of the policymakers at the Fed worried that some paragraphs of the statement might stir the market to a wrong way. To be more precise, Minnesota Fed President Narayana Kocherlakota was the only voting member who voted against the Fed's decision to remove the key number of 6.5% from the statement. He says that the a paragraph in the statement may signal the Fed's weakness when it comes to reaching the long-term inflation rate of 2%. The paragraph he was referring to is following:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored [emphasis added].

It seems like the last sentence could have caused Mr. Kocherlakota to vote against the action because of it's  possible inference of a lasting low inflationary period. As low inflation has continued since 2012, inflation expectation, also, hasn't been reaching the goal of 2%. The expected inflation in 10 years is still lower than 2%. The following graph provided by the Cleveland Fed shows the market's expectation of inflation in certain time horizons :

Considering the low expected inflation in next few years, Mr. Kocherlakota's worry of weakening the credibility of the Fed's commitment to the 2% inflation is indeed valid. The Fed's main goal thorough its forward guidance is to lower the expected interest rate for certain duration, but it's another goal from which the FED is quite away from reaching it is to raise the inflation expectation, which in turn lowers the real interest  rate and boost investment.

Now let me interpret the Fed's statement in my way. The WSJ posts an interesting post on how the latest Fed's statement changed from last month's. The following passage shows the change made in the statement from last month:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate
well past the time that the unemployment rate declines below 6-1/2 percentfor a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal
. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent, and provided that longer-term inflation expectations remain well anchored.

As we see from the change made in the statement, the Fed untied the possible date of raising interest rate from the unemployment rate and related it more to the Fed's tapering process and its ending. Now, the Fed watchers should be giving more weights to the tapering process than before since it is now more related to the raise in interest rate.

This change could be progress forward for the Fed because as the tapering continues for at least throughout 2014, the market will have stronger signal of the Fed's raising interest rate in near future. Even though then higher expected interest rate might seem worse for the economy, raised expected interest rate could actually induce more investment today, which is opposite to what one might assume. Because, the market will be surely knowing the coming of the raise in the interest rate in few months, firms should take advantage of the low interest rate today by borrowing and investing rather than postponing the investment project. This idea of surely known interest rate increase could create more investment is explained in my one of the previous posts.

*UPDATE: After posting this, I watched Mrs. Yellen's press conference following the FOMC meeting. When one of journalists asked exactly how much time the Fed will take to raise the interest rate after it completely stops its large-scale asset purchase aka QA, she answers (from the press conference transcript):

 So, the language that we use in this statement is considerable, period. So, I -- I, you know, this is the kind of term it's hard to define, but, you know, it probably means something on the order of around six months or that type of thing. But, you know, it depends -- what the statement is saying is it depends what conditions are like.

I don't want to make a big deal out of that "around six months" as some are doing. But it gives "considerable" idea of how long is that "considerable"