MacroScope

This post was based on reporting by Leika Kihara in Tokyo

Japan has crossed the monetary rubicon: the government is actively intervening in the affairs of the central bank, pressuring it to more aggressively tackle a prolonged bout of deflation and economic stagnation. The Bank of Japan is expected to discuss raising its inflation target from the current 1 percent level during its next rate decision on January 21-22.

Overnight, a Japanese newspaper reported the finance ministry and the central bank were considering signing a policy accord that would set as a common goal not just achieving 2 percent inflation but also steady job growth.

Key Japanese policymakers played down the prospect of making the BOJ responsible for stable employment like the U.S. Federal Reserve, but said a 2 percent inflation target will be at the heart of a new policy accord with the central bank.

That type of language sounds an awful lot like the advice Fed Chairman Ben Bernanke offered Japan in 2003, when he was a governor on the Fed’s board.

There is no unique solution to the problem of continuing declines in Japanese prices; a variety of policies are worth trying, alone or in combination. However, one fairly direct and practical approach is explicit (though temporary) cooperation between the monetary and the fiscal authorities. Let me try to explain why I think this direction is promising and may succeed where monetary and fiscal policies applied separately have not.

When Federal Reserve Chairman Ben Bernanke was last in New York, he joked about his past research into the effect of uncertainty on investment spending. “I concluded it is not a good thing, and they gave me a PhD for that,” he said, drawing laughter from a gathering of hundreds of economists in a packed Times Square conference room.

Laughter probably wasn’t echoing through the halls of the U.S. central bank on Wednesday. Late on Tuesday, Congress struck a last-minute deal that only partially and temporarily avoids the so-called fiscal cliff. Bernanke and other Fed policymakers – frustrated that it took politicians so long to address tax and spending levels in the first place – were hoping Washington would agree to a bi-partisan, longer-term plan to narrow the country’s massive deficit with only modest near-term fiscal restraint. While no deal on taxes would have been far worse for the economy, the fact that Congress put off decisions on government spending and the debt ceiling for another two months simply prolongs the uncertainty that many feel is holding back investments by businesses and households.

“You basically continue this fiscal policy uncertainty that we have had for the past year or more,” said Roberto Perli, managing director of policy research at International Strategy and Investment Group. In a note to clients, Perli predicted that at best the fiscal cliff deal does not change the outlook for Fed policy, which for now consists of rock-bottom interest rates and $85 billion per month in asset purchases. But more likely, he wrote, it would lead to even more accommodation from the Fed since Republicans – smarting from a political defeat in the last few days – may prefer to let the “sequester” of large-scale spending cuts kick in as scheduled on March 1 rather than agreeing to a smaller reduction in U.S. debt. In that case, the Fed would respond by keeping rates lower for longer, perhaps through early 2016, or simply by ramping up the value of asset purchases under its quantitative easing program (QE3), Perli wrote.

Economic forecasters divide into two groups: those who cannot know the future but think they can, and those who recognize their inability to know the future. Shifts in the economy are rarely forecast and often not fully recognized until they have been under way for some time. So judgments about the U.S. economy have to be tentative. What can be said is that for the first time in five years a resumption of growth significantly above the economy's potential now appears as a substantial possibility. Put differently, after years when the risks to the consensus modest-growth forecast were to the downside, they are now very much two-sided.

As winter turned to spring in 2010 and 2011, many observers thought they detected evidence that the economy had decisively turned, only to be disappointed a few months later. A variety of considerations suggest that this time may be different. Employment growth has been running well ahead of population growth. The stock market level is higher and its expected volatility lower than at any time since the crisis began in 2007, suggesting that the uncertainty hanging over business has declined. Consumers who have been deferring purchases of cars and other durable goods have created pent-up demand. The housing market seems to be stabilizing. For years now, the rate of family formation has been way below normal as young people moved in with their parents. At some point they will set out on their own, creating a virtuous circle of a stronger housing market, more family formation and demand, and further improvement in housing conditions. Innovation around mobile information technology, social networking and newly discovered oil and natural gas is likely, assuming appropriate regulatory policies, to drive significant investment and job creation.

True, the risks of high oil prices, further problems in Europe, and financial fallout from anxiety about future deficits remain salient. However, unlike in 2010 and 2011, it is probable that these risks are already priced into markets and factored into outlooks for consumer and business spending. There has already been a significant escalation in oil prices. The European situation is hardly resolved but is unlikely to deteriorate as much in the next months as it did last year. And market participants report great alarm about the deficit situation. So it would not take great news in any of these areas for them to actually contribute to upward revisions in current forecasts.

Two academics from the Fletcher School at the Tufts University have written a special guest blog for Macroscope on the impact of the euro zone debt crisis on sovereign wealth funds.

Dr. Eliot Kalter is a senior fellow, The Fletcher School at Tufts University, Sovereign Wealth Fund Initiative, and president of E M Strategies, Inc. Thomas F. Holt, Jr. is an adjunct professor of law, The Fletcher School and partner in the global law firm K&L Gates LLP.

“While Sovereign Wealth Funds (SWFs) vary widely in their size and investment objectives, continuing tensions in the euro zone and in global markets more generally can only accelerate their concerns about investing in the West.  Significantly, in a last month’s meeting of SWFs in Sydney, the political focus shifted from questions raised by recipient countries about SWFs’ accountability and transparency to the risks inherent when investing in heavily indebted countries and the need to improve existing risk management frameworks.  Although SWFs account for less than 6 percent of total assets held by global institutional investors, they are an important barometer of global capital flows because of their clean balance sheets, long-term investment horizons and ability to invest large and growing amounts of capital quickly.