Reinforcing the three arrows

Reinforcement of the first two arrows of Abenomics

In the past week, we have seen a reinforcement of the first two arrows of Abenomics.

The first arrow, bold monetary policy, was reinforced in July 29 when the Bank of Japan decided to double the purchase of ETFs.

The second arrow, flexible fiscal policy, was reinforced in August 2 when the government announced a new economic stimulus package.

Enhancement of monetary easing

The reinforcement of the first arrow is a response to the increasing uncertainty surrounding the future of the economy. In view of the weak developments in prices, however, the action taken in July is obviously not enough. The most recent data (June 2016) shows that the headline CPI inflation rate is still a minus 0.4 percent. Even if we exclude fresh food and energy, which is BOJ’s favorite index, it is only 0.8 percent. BOJ expects the inflation rate to reach 2 percent some time during FY2017, but that could turn out to be optimistic given the unfavorable developments in the global economy including the Brexit. Some additional measures would have to be introduced in the near future if the inflation target is to be maintained.

As for the measures to be employed, the BOJ this time chose to double the purchase of ETFs, rather than expanding government bond purchases or reducing the negative interest rate. From the point of view of the transmission of monetary policy, I view this as appropriate. That is because what we are witnessing is a limited impact of monetary policy that is designed to work through commercial banks. Even though BOJ injects liquidity through purchase of government bonds, banks are unable to increase bank lending in a significant way. In such a situation, applying negative interest on a portion of banks’ current account balance at the BOJ to pressure banks to lend more or invest more should also face a limit. Taking these into account, injecting liquidity directly to the market by purchasing ETFs should be a more promising monetary measure.

A new economic stimulus package

The new economic stimulus package of a size of 28 trillion yen is also intended to address the weak economic activity and downside risk surrounding the future of the Japanese economy. It includes measures to improve child care and long-term care systems, to increase scholarships available to students, and to support low income earners. These are in addition to increased spending on social infrastructure. Efforts are made in order to pursue two objectives at a same time: addressing medium-term structural issues while pursuing short-term demand stimulus.

Some express disappointments with respect to the magnitude of fiscal expenditure being only 7.5 trillion yen, or 1.5 percent of GDP. We can always ask for more. But we mustn’t forget the serious fiscal situation that we face. The Cabinet Office has just published its new medium to long-term economic and fiscal projection (July 26). It shows that Japan still has a primary deficit of 3.1 percent in FY2016 (obviously, it should be larger if we incorporate the newly introduced economic stimulus package). It also shows that, unless we introduce additional deficit-reducing measures, we will fail to achieve the government’s own fiscal consolidation target of achieving a primary surplus by FY2020: It is projected that we would still be left with a primary deficit of 1~1.7 percent of GDP at FY2020. It shows that we did not have a considerable “fiscal space” to start with. The seemingly limited magnitude of the fiscal expenditure should be considered as a result of trying to strike a balance between expansionary fiscal policy and fiscal consolidation.

Helicopter money operation

A recent popular subject that is related to both monetary and fiscal policies is “helicopter money.” Some suggests that the policy option should be implemented in the near future. However, in a way, we are already engaged in a helicopter money operation: We have already being expanding fiscal expenditures, including direct transfers to the households, by central bank purchase of the government bonds and expansion of the monetary base.

Of course, strictly speaking, helicopter money requires the government debt to be free from repayment (issuing a kind of consols). This is needed in order to avoid the stimulus-offsetting behavior of rational households; increasing their savings in preparation for the expected tax increase needed to finance the government debt redemption. However, Japanese economy never has been an economy where Ricardian Equivalence Theorem holds in its strict sense, and whatever offsetting behavior that may have taken place has been limited.

Reinforcing the third arrow

We have seen reinforcements in the first and the second arrows of Abenomics. Probably, additional reinforcement would follow, especially in the monetary policy front, in the near future. They are certainly important, but the impact of them alone would be limited. The three arrows would show its maximum effect only when they are combined together (the lesson of Mori Motonari).

In this respect, what we are waiting for is the reinforcement of the third arrow, the growth strategy. In the area of structural reforms, on top of the long list of agenda is the labor market reform. It is a long awaited and a crucially important reform. In this respect, it is encouraging that the new Abe cabinet reshuffled in August 3 includes a newly created minister in charge of labor market reform. It is hoped that it shows the strong determination of the administration in pursuing the reform.