The operative theory behind QE relates to the academic exercise of overcoming the real world constraint of nominal interest rates, called the zero lower bound (ZLB). Once the offending central bank has pushed rates to the ZLB, conventional monetary science posits only extraordinary means to overcome this limitation. After all, central banks cannot be impotent in the face of the real world, as the “toolkit” extends into all manner of classroom-developed theories and exercises.

That is the measure of QE’s existence despite many instances of real world testing. While the Fed is officially in its third iteration, there is a real distinction between the program that was implemented in September 2012 (MBS) and that which began in December 2012 (UST). For its part, the Bank of Japan is actually on its tenth or eleventh episode of QE, having run into the ZLB back last century.

The stated goal of QE at the ZLB is forward economic momentum enforced through inflation expectations. This is where the theory of rational expectations meets the real world of modern finance and collateral. Theoretically, the increase in central bank balance sheet size corresponds with “market” expectations for future inflation through perceptions of “money printing”. We are not talking about commodity prices either, but full-blown, official version of inflation – rising incomes.

The process is supposed to work as a means to first stimulate some measure of credit-driven activity coupled to those expected inflationary expectations. As companies view a rising anticipation for future costs of production, they move up production and investment before costs rise. That rush of initial activity turns into jobs and growing incomes, hopefully to the point that the labor market begins to run short. Once that takes place, the competition for workers produces inflation as conventional economics defines it.

A funny thing always happens on this road to central bank utopia. The real markets tend to deviate from the script, as it were. There is a very real difference between theory and practice, perhaps more so in economics than in any discipline.

While there have been no shortage of examples of this in the United States, the activity recently in Japan provides another “lesson”. Step 1 was complete long before QE-steroids was actually launched. In anticipation of that massive QE, the yen began a dramatic slide against the dollar and other currencies, just as expected. That was supposed to both drive inflation expectations inside Japan as well as increase export activity.

Setting aside the export market (which, apparently alluding academic planners, is not just dependent on the currency exchange but also intrinsic demand inside export target regions), the Japanese have certainly begun to feel the pinch of the commodity side of pricing pressures. From electricity to fuel to McDonald’s hamburgers, anything related to the yen and importation has increased in price. That has been welcomed by the “market” as proof of QE efficacy.

The next expected step is the corporate response to these inflation-related pressures. Where the academic theory posits a burst of activity to transmission monetary expectations into income growth, instead real world corporations deal with cost pressures in real world ways.

As we learn from Bloomberg, many companies in Japan are responding by shipping productive capacity overseas. Rather than pass along price increases inside Japan where demand remains constrained or commit to a burst of “investment” and hiring, there is real bottom line pressure to cut costs in the supply chain and harmonize with end markets. Instead of working as expected, this actually is counterproductive toward the final goal of officially defined “inflation”.

“The trend to build factories in destination markets helps explain why the yen’s slump is doing less to boost the economy than in the past. Japan exported 5.8 trillion yen ($62 billion) of goods in April, the same amount as in February 2006, when the yen was 17 percent stronger, and Abe was chief cabinet secretary.”

In a parallel effort, Japanese authorities are already moving to ensure that tax increases planned for next year do not likewise get buried in supply chain maneuvering. In other words, Japanese authorities are actively trying to enforce increasing prices through taxation. Again, theory meets reality in that, if this inflation exercise continues to fail to meet its objectives, as the tax increase gets passed to consumers there will be a drop in volumes. Unless incomes rise as predicted, the increase in price will simply adjust through lower internal activity.

As much as Nikkei volatility relates to liquidity pressures in the JGB market, there is at least some element of this potential disconnect between theory and reality in the market “pause” over the past month.

 

Click here to sign up for our free weekly e-newsletter.

“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, contact us at: jhudak@4kb.d43.myftpupload.com or 561-686-6844 . You can also book an appointment for a free, no-obligation consultation using our contact form.