QE, inflation, and Japan

I think the discussion on whether the implementation of QE, low-interest rates and prices in Japan is something that we are not able to answer directly. I've given some thoughts for the past 2-3 years, and for the past several days, I've been thinking that maybe that we have been asking the wrong questions, and maybe we (especially the Bank of Japan) have been looking at the wrong picture.

This whole discussion reminds me of Milton Friedman's quote:

"Inflation is always and everywhere a monetary phenomenon."

I think Friedman's right. Inflation should be a monetary phenomenon. This is assuming that more money is being pumped into the economy, while households and businesses are chasing limited goods and services, this will drive prices up.

But I also think Friedman is wrong. Maybe after the Great Moderation, there were other exogenous factors that we weren't able to quantify, such as the rise of emerging economies (especially China) and technological advancement that keep prices low.

So, does this answer why Japan's inflation so low for the past three decades? Maybe yes. The Bank of Japan had done everything within their capabilities by pushing the interest-rates low and expanding its balance sheet. In theory, this should able to stimulate aggregate demand and produce more output and push prices up. 

But if we look at the chart below, the correlation between money growth and prices is weak.

Most literature tried to answer why this happened. The one I just read by Bowman et al. (2010) hinted at two different factors but unfortunately did not emphasize in details why:

"It is possible that QEP exerted positive effects, but that these were simply overwhelmed by the drag on aggregate spending coming from severe weakness in the banking sector and balance sheet problems among households and firms."

In my opinion, it is probably fair to say that the BoJ might be underestimating these two factors. That could explain why, despite the extra-loose monetary policy, prices have stubbornly stayed low.

I should re-read Richard Koo's book then this weekend.

PS: Turned out those three papers I mentioned in my previous post will take some time to digest.

Source:

Bowman, D., Cai, F., Davies, S. M., & Kamin, S. (2010). Quantitative Easing and Bank Lending : Evidence from Japan. International Finance Discussion Paper, 2010(1018), 1–31