MacroScope

The governor of the Bank of Japan, Masaaki Shirakawa, says he is confounded by the still very low level of Japanese government bond yields given the country’s elevated debt to GDP ratio of over 200 percent. Speaking on an IMF panel over the weekend, he offered a rather unintuitive explanation for the phenomenon:

It seems difficult to explain the case of Japan in light of conventional wisdom. One frequently offered explanation is that the ample domestic savings in Japan have absorbed the issuance of JGBs and the share of JGBs held by foreign investors is very small. But a more fundamental explanation is that the stability in the current bond yields reflects market participants’ expectations that fiscal soundness will be restored through structural reforms imposed in the economic and fiscal areas.

Most economists think Japanese yields are low because of continued expectations for deflation and weak economic growth. But for Shirakawa, it seems, it is public confidence in future fiscal restraint that is keeping bond yields low. Except he then contradicts this point by saying weak confidence in future fiscal reforms is also simultaneously undermining consumer spending:

At the moment, such expectations are not firmly backed by concrete reform plans. The public therefore restrains spending on concerns over future fiscal developments. This constitutes one factor behind sluggish economic growth and mild deflation. If this is indeed the case, the experience of Japan indicates a possibility that a cumulative increase in government debt combined with weak economic growth expectations might generate deflationary pressures.

Not so, argues Ugo Panizza, head of debt and finance analysis at the United Nations Conference on Trade and Development. He and co-author Andrea Presbitero find no causal link between high debt levels and weak economic growth.

The focus is already on the euro zone finance ministers meeting in Copenhagen, starting on Friday, which is likely to agree to some form of extra funds for the currency bloc’s future bailout fund. What they come up with will go a long way to determining whether markets scent any faltering commitment on the part of Europe’s leaders.

In the meantime, top billing goes to Bundesbank chief Jens Weidmann speaking in London later. He is heading an increasingly vocal group within the European Central bank who are fretting about the future inflationary and other consequences of the creation of  more than a trillion euros of three-year money. There is no chance of the ECB hitting the policy reverse button yet but the debate looks set to intensify.
A combination of German inflation and euro zone money supply numbers today (which include a breakdown on bank lending) will give some guide to the pressures on the ECB.

Central bankers face a very mixed picture with U.S. recovery and high oil vying with the unresolved euro zone debt crisis and signs of slowdown in China.

The financial turmoil still dogging Europe is most often described as a debt crisis. But sovereign debt is only part of the problem, according to new research from Jay Shambaugh, economist at Georgetown’s McDonough School of Business. The other two prongs of what he describes as three coexisting crises are the region’s troubled banks and the prospect of an imminent recession.

These problems are mutually reinforcing, and require a more forceful policy response than the authorities have delivered to date. In particular, Shambaugh advocates using tax policy to lower labor costs, fiscal stimulus from those economies strong enough to afford it, and more aggressive action from the European Central Bank:

It is possible that coordinated shifts in payroll and consumption taxes could aid the painful process of internal devaluation. The EFSF could be used to capitalize banks and to help break the sovereign / bank link. Fiscal support in core countries could help spur growth.  Finally, the ECB could provide liquidity to sovereigns and increase nominal GDP growth as well as allow slightly faster inflation to facilitate deleveraging and relative price adjustments across regions.

Economists seeking insight into the kind of analysis the European Central Bank is using to support its policy decisions can get hints from its monthly bulletin. Not for everyone, but here’s what is in March’s edition:

* The effective exchange rates of the euro – revised trade weights in the light of global economic integration

* Recent developments in the financial account of the euro area balance of payments

There’s a sense of relief among European policymakers that the worst of the euro zone’s crisis appears to have passed. Olli Rehn, the EU’s top economic officials, talked this week of a “turning of the tide in the coming months”. Mario Draghi, the president of the European Central Bank, speaks of “sizeable progress” and “a reassuring picture”.

At last week’s spring summit, EU leaders couldn’t say it enough: “This meeting is not a crisis meeting … it’s not crisis management,” according to Finnish Prime Minister Jyrki Katainen. All the talk is of how the euro zone’s economy will recover in the second half of this year.

But for the 330 million Europeans who make up the euro zone, the outlook has, if anything, darkened. As euro zone governments deepen their commitment to deficit-cutting, and rising oil prices mean higher-than-expected inflation, households can’t be counted on to drive growth. Not only did housing spending fall 0.4 percent in the October to December period from the third quarter, but unemployment rose to its highest since late 1997 in January.

Ask not what your monetary policy can do for you, but what you can do for your monetary policy. That’s the jist of a 1968 paper by Milton Friedman, the poster-child for monetarist economics, entitled “The Role of Monetary Policy,” whose key questions remain hotly debated more than four decades on. Friedman’s answer is simple (some might argue too simple), and all too familiar to those who read the speeches of present-day Federal Reserve hawks – focus on the only thing monetary policy can truly control, which in Frideman’s view is price stability.

By setting itself a steady course and keeping to it, the monetary authority could make a major contribution to promoting economic stability. By making that course one of steady but moderate growth in the quantity of money, it would make a major contribution to avoidance of either inflation or deflation of prices. […] That is the most that we can ask from monetary policy at our present stage of knowledge.

Friedman’s writing suggests he was not a big fan of the Fed’s own dual-mandate, introduced in 1978. Any effort to goose employment through a persistent period of low very low interest rates, Friedman argues, would likely lead to overshooting and inflation.

Economic forecasters, including those at the Federal Reserve, have notoriously poor aim. Last month, the central bank revised sharply lower its projections for U.S. gross domestic product in 2012 – just as U.S. data began to turn in a more positive direction.

But at least one Fed call appears to be on the mark: overall inflation is coming down as energy prices ease on the expectation of slowing global demand. This, in turn, may soon lead to a curious phenomenon. The core measure of costs, which excludes energy and food prices and tends to be lower than consumer prices as a whole, may soon exceed so-called “headline” inflation.

Eric Green at TD Securities, writes in a research note:

The November CPI data was benign and captures a trend over the next six months that will become more obvious – headline is poised to decelerate through core prices. Core inflation will prove more sticky to the upside rising toward 2.3% y/y over coming months while headline prices fall toward 1% y/y by May. That will encourage a perceptible bias lower in breakevens (one that could accelerate if Europe goes Kaboom in Q1), and it provides the Fed more leeway to become more proactive should growth decelerate over H1 as we suspect it will.

It may be hard to convince consumers with stagnant wages that their purchasing power is improving. But according to Labor Department, inflation is certainly on the decline. U.S. consumer prices fell unexpectedly in October, a drop that gives the Federal Reserve more room to consider additional monetary easing if the economy continues to stutter into next year.

Compared to a year earlier, consumer prices rose 3.5 percent following September’s 3.9 percent increase. Core prices rose 2.1 percent in the 12 months through October, up from 2.0 percent in September. But looked at over shorter horizons, the pullback in the rate of consumer price growth is even more pronounced.

Research from Credit Suisse economists puts it in perspective:

The 0.4 percentage point easing in the year-on-year headline inflation rate was the first (drop) all year and the biggest since June 2010. Short run trends were as follows: 2.4 percent 3-month annualized from 4.8 percent last month; 2.1 percent 6-month annualized from 3.1 percent last month.

As policymakers debate how to bring down an unemployment rate stubbornly stuck above 9 percent, Chicago Federal Reserve Bank President Charles Evans and Boston Fed President Eric Rosengren are embracing what might be called “the seven-percent solution.”

It works like this: the Fed pledges to keep rates near zero for as long as it takes to get some real improvement in the labor market – an unemployment  rate, say, of 7 percent – as long as inflation doesn’t get out of hand. That way, every time some good economic news comes out, markets don’t immediately start pricing in a rate hike, undoing the very easy policy that the Fed sees as necessary to pull the moribund jobs market from its deep hole. Don’t you worry about a little bit of inflation here or there, the Fed could say –  it’s steady as she goes until unemployment dips below 7 percent.

What, though, is so special about 7 percent? Certainly, it’s much better than the current 9.1 percent. But it still would leave millions unemployed, and Evans himself has said he believes that unemployment normally runs at less than 6 percent. Why settle for a bigger number?

The Federal Reserve’s long-quiet doves are becoming increasingly louder about championing more aggressive forms of monetary easing, including possibly setting employment and inflation targets and/or engaging in another round of bond purchases. Most prominent among these have been Charles Evans, the Chicago Fed president who openly favors more transparent policy guidance and Eric Rosengren, who told CNBC on Wednesday a third round of monetary easing could be in store:

If the economy were to be weaker than most people are forecasting, that would certainly be cause for doing additional monetary policy.

Rosengren also said he favors more explicit policy targets, which could take a rather controversial form known as price-level targeting. Under this arrangement, the Fed would temporarily shoot for higher inflation to make up for the almost deflationary readings seen late last year, in an effort to boost investment, spending and hiring.