Timely commentary from Richard Koo of Nomura here who says that the currency markets are misunderstanding the impact of QE. Given the BOJ’s open-ended commitment to QE that was just announced, it’s interesting to see how the markets are indeed responding to the big talk out of BOJ. Whether they can deliver is a whole different matter. Koo clearly thinks they can’t:
“I worry that recent moves in the forex market have been driven solely by announcements regarding quantitative easing and not by the relative changes in actual money supply.
This is an indication that many forex market participants remain unaware that the relationship between the money supply and the monetary base has since 2008 (and since 1990 in Japan) morphed into something very different to what the textbooks predict.
Prior to these bubbles, base money and the money supply tracked each other almost perfectly across the industrialized world. Knowing one of these variables, it was easy to assume what had happened to the other. Since the bubbles burst, however, this relationship—like the one between base money and inflation—has collapsed.
Behind the breakdown of both these linkages is the fact that the private sector, which is dealing with balance sheets impaired by the collapse of an asset bubble, has not only stopped borrowing but has also been paying down debt, prompting the money multiplier to turn negative at the margin at times.
That is why central bank monetary policy has lost so much of its potency in Japan and other developed economies in the postbubble era.”
As I’ve said before, this is one of the most interesting policy experiments currently occurring in the world. If the BOJ succeeds here it could change the way the world approaches policy. Indeed, the concepts of the “wealth effect” and talking up markets will become an even more pervasive and outright policy approach.
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