Monday, 28 May 2007

Japanese Monetary Policy Oxymoron - A Contractionary Stance to Boast Consumption

I have come across many commentaries lately suggesting that the Bank of Japan should stop its next to zero interest rate policy (n-ZIRP?) and increase rates to boast household consumption. For example, Oxford and Yale trained Thomas Palley wrote this on Project Syndicate:

How Japan Fuels Global Financial Instability

... the policy of ultra-low interest rates may also be bad for Japan. This is because ultra-low interest rates may hurt Japan’s households and lower consumption, and this effect may be larger than the benefit that a weak yen confers on Japan’s exports.

Higher interest rates can spur consumption if their impact on income outweighs the increased incentive to save. This may well be the case for Japan, which has a rapidly aging population. Current ultra-low interest rates may be scaring people about the adequacy of future income. Raising rates could alleviate those fears, increasing consumer confidence and spending.

Additionally, raising interest rates would be a form of expansionary fiscal policy. This is because Japan has a large public debt, and increasing interest payments on that debt would put extra money in the hands of households...

My intuitive reaction to this kind of statement is ..." this couldn't be right". But without the luxury of time and the incentive to investigate the claim further, I couldn't quite coherently argue why it is so. The naggy feeling remains, akin to the naggy feeling I got after reading "Malcolm Gladwell's Bl!nk: The Power of Thinking Without Thinking" - something is just not right.

Anyway, last friday, Takehiro Sato, Morgan Stanley economist on Japan wrote this piece which I am significant more sympathetic towards:

Misconceptions on Consumption

Can an increase in deposit interest rates lead to a self-sustaining consumption path?

There are some quite enthusiastic adherents to the hypothesis that an increase in deposit rates, due to an interest rate hike, will stimulate spending. But consistent increases in deposit rates are a must for such income gains on bank deposits to have a steady stimulatory effect on spending. This type of view just is not logical, however, when you stop to think about it.

Let’s look at a basic example. The BoJ’s cumulative 0.5% policy rate hike has resulted, overall, in a 0.2% demand deposit rate currently. Money supply data indicate that individual bank deposits total ¥450 trillion (as of March 2007), and assuming a parallel shift in all durations of deposit rates as well means that a 0.2% deposit rate increase would create full-year income gains of ¥90 billion (or about 0.3% of disposable income). The assumption is that this flows entirely into consumption. However, this type of interest income cannot be expected to stimulate spending additionally in the following year without consistent increases in deposit rates, and results in basically no marginal increase. Basically, rate hikes of 0.5% annually are needed to reap this degree of income gain. While verifiable analysis is still necessary to tell whether such income gains can be fully passed on to consumption, this argument does not intuitively hold water for us.

.... (read the rest for more detailed arguments)

However, I doubt that this provides a definitive conclusion to the matter.

Fellow economists and others out there, what do you think?

Good Monday morn',


__earth said...

I think there is truth to both sides though obviously, we need data to prove it.

While higher interest rate does discourage consumer spending while encouraging consumer saving, it does create a larger pool of savings for investment purposes. I am sure a lot of people would love to borrow money when the interest rate is 0% but how many people would lend their money under the same circumstances?

This reluctance to lend might prevent growth because borrowers cannot get the fund they need.

Regardless, I think the main concern is that BoJ needs to find the right level of savings. For this scenario, assuming there are two kinds of spending (consumer and corporate[investment?]), the BoJ needs to find a rate that produces positive net spending, if economic growth is in its charter rather than price stability.

Jien Sing said...

I don't get it. Does he mean printing more money to increase the inflation rate?