Balance Sheet Anxiety (What almost everyone gets wrong)

The Wall Street Journal has a very interesting story on the BOJ, which faces an important policy decision on Wednesday:

Until recently, Bank of Japan Gov. Haruhiko Kuroda managed to keep a fragile majority on the nine-member board in favor of his preferred easing steps. A decision in January to introduce negative rates on certain commercial-bank deposits passed 5-4. Two of the dissenters later left when their terms expired, replaced by supporters of easing.

That should have given Mr. Kuroda a comfortable majority. But the seven supporters of easing now have fractured over where to go next, say people familiar with their thinking.

At least three in this camp favor sticking with the plan, convinced that both huge government bond purchases and negative rates are still effective in forcing private money to flow into riskier assets. This faction thinks curbing those purchases, or even tinkering with the buying formula in a way that markets might perceive as tightening, could send the yen soaring, according to people familiar with its views, which is the opposite of the policy’s intended effect. That could hit corporate profits and the stock market.

Others, while still pro-easing, are no longer confident bond purchases can get the job done. Some including BOJ staff have floated the idea of flexibility in the buying. In place of the current commitment to buy ¥80 trillion of government bonds a year, some in this group have suggested a range, perhaps ¥70 trillion to ¥90 trillion.

The two sides get particularly heated over whether Japan is running out of bonds to buy, according to people familiar with the deliberations. The pro-flexibility faction says the practical limit could come in the next year or two as banks, which often use government bonds as collateral in day-to-day operations, become reluctant to sell more of their holdings to the central bank.

These board members believe the BOJ should begin looking for policy alternatives, according to people familiar with their thinking, such as introducing a target for long-term interest rates and pledging to buy only the amount of bonds needed to guide rates to that target.

The thought is that such a move–which former Fed Chairman Ben Bernanke has endorsed as an option in certain situations–could reassure people that borrowing costs will stay low while giving the BOJ room to reduce purchases if necessary.

Opposing the idea, one easing proponent said “any grade-school student can tell with a little arithmetic” the BOJ can’t buy bonds forever, “but it’s strange to be deciding policy today based on some future limit when…we haven’t reached that limit.”

The seven pro-easing board members nonetheless agree that lowering interest rates further into negative territory should remain as an option.

I find that both sides of the monetary policy debate miss a very important point. In the long run (and even in the medium run), the slower the rate of NGDP growth, the larger the share of NGDP held in the form of base money. This is the “inflation or socialism” trade-off that Nick Rowe and I frequently discuss.

Most of the world sees things very differently. They see a bigger central bank balance sheet as being expansionary (and sometimes it is) and expansionary policies leading to faster NGDP growth. In this view, bond purchases become “ammunition” to be used to propel the economy toward higher NGDP growth. In contrast, I see QE as mostly the effect of low NGDP growth. The central bank accommodates the public’s growing demand for zero interest base money as NGDP growth slows.

Why is NGDP growth so important? Because the long run rate of NGDP growth is positively correlated with the nominal return on owning stocks, bonds and real estate, which are all substitutes for holding base money. In countries with very rapid NGDP growth, people and banks don’t want to hold very much zero interest base money–they have better options.

If anxiety over a large balance sheet causes a central bank to refrain from purchasing assets, this will slow the rate of NGDP growth. In the long run this will lead to more demand for base money, which the central bank must eventually accommodate if it wants to avoid a depression. Thus if the Japanese demand for base money doubles from 20% of GDP to 40% of GDP, the BOJ must either double the base, or see NGDP fall in half. The US tried the latter approach in 1929-33, and it didn’t turn out very well.

This relationship is often hard to see, because in the short run the correlation between QE and NGDP growth may be positive and (more importantly) because what matters is expectations of future policy, not current changes in the base.

I’ve developed a graph that allows readers to visualize this point. The two convex lines are PPFs—policy possibility frontiers. I’ll focus on the one assuming no interest on reserves (IOR=0%). That line shows all the possible combinations of NGDP growth and base/NGDP ratios, in the long run. If NGDP growth is extremely high (almost always due to high inflation), people won’t want to hold much base money—say 2% of GDP. That might be a country like Venezuela. At a somewhat lower NGDP growth rate, base demand will be higher. Australia’s base has been about 4% of GDP in recent decades. The US has still lower NGDP growth, and a base of over 20% of GNP. And Japan’s NGDP growth rate has averaged about zero in the past 22 years, and its base to NGDP ratio is roughly 80% of NGDP.

So the two lines that slope down and to the right show the tradeoff between inflation and socialism. If you want lower NGDP growth (i.e. lower inflation), then the public will demand more base money as a share of GDP, and the central bank will end up owning a bigger share of the economy. That’s not a problem if all they own is government bonds, but the BOJ has also purchased equities.

Put aside your own view on big central bank balance sheets. Let’s take the central bank anxiety as a given. Suppose the target NGDP growth rate is 4%, which is assumed to best trade off the costs of low NGDP growth (an inefficient labor market) and higher NGDP growth (inefficient excess taxation of capital income.)

Central banks then have “policy indifference curves” which are sets of points that are equally desirable to policymakers. I’ve drawn three of them, rippling out from the (assumed) optimal 4% NGDP growth point. (I assumed a zero balance sheet is optimal, which is unrealistic, but changing that to 5% of GDP would not change anything important—you’d have circles instead of semicircles for indifference curves.)

As you go further out from the 4% optimal point, policy becomes less desirable. In this exercise, Australia reached the highest policy indifference curve, while the other three had either too much NGDP growth (Venezuela) or too big a balance sheet (the US and Japan.)

With the exception of a few market monetarists, almost no one understands these trade-offs. Over the past 7 1/2 years I’ve devoted far more time to trying to convince people that this is the right way to look at the world, than I have to defending NGDP targeting.

People at the Bank of Japan and the Swiss National Bank think they can have a smaller balance sheet if they adopt a tighter monetary policy, but in the long run just the opposite is true. On the other hand, it’s hard to blame them, because in this case the truth is far stranger than the fiction. Here’s the truth:

If the BOJ want’s to avoid a socialist outcome, where it owns much of the Japanese economy, then it should announce the following policy on Wednesday:

“We plan to start buying massive quantities of a wide variety of assets, and will continue doing so at a rapidly accelerating rate, until NGDP growth expectations rise to 4%”

That’s what the Bank of Japan should do Wednesday if it wants a smaller balance sheet. No wonder only a few lonely market monetarists see the world this way, it’s about as counterintuitive as you can get.

PS. My dream is that someday this graph appears in Mishkin’s money textbook. In that case I’ll die a happy man.