IN MAY 2003, Ben Bernanke, who at that time was yet to become chairman of the US Federal Reserve, spoke to a group of economists in Tokyo. He suggested that they would have a better chance of escaping deflation if they targeted not just the prospective inflation rate but also the prevailing level of prices.
He could scarcely have imagined that, 14 years later, he would be offering the same insight to western central bankers. His language has changed, with the concept of price level targeting replaced by the more simplistic notion of make up, where prices should be allowed to rise unchecked until they have recovered to the level implied by the target trend inflation rate.
However, the sentiment is the same: resisting deflation requires new ways of thinking.
Critics of the approach worry that monetary policy might, when prices are above those implied by long-term trends, have to be tightened when the economy is already slowing down. Unusually for a man so prescriptive, Bernanke’s response is simple: make up should only be applied when it suits.
Perhaps making it up as you go along is a better description of the proposal.
This year has been a good one for investors. Against a backdrop of stable bond yields, equity markets have kicked on, bolstered by stronger corporate performance consistent with the well-balanced and reasonable healthy world economy.
It has not just been investors that have been keen to exploit these conditions, however. Central bankers in the west are rushing to normalise by withdrawing their various extraordinary monetary stimuli, whether by hiking rates or by reversing quantitative easing (QE).
While policy change has been brewing, the European economy, boosted by previous currency weakness, by negative interest rates and the relief that several more adverse political outcomes were avoided, has seen its summer strength start to succumb to the higher euro, buoyed in part by hopes of tighter monetary policy.
In the US the Fed, which has raised rates four times, has revised down its equilibrium interest rate despite recent economic strength. Each time it tightens, the target it is aiming for comes down - hardly a sign of normalisation.
The Bank of Japan, hardened by long, bitter experience, is less inclined than its counterparts to take recent improvements on trust. Too many times has Japan suffered from premature policy tightening.
It has been very clear: QE, negative policy rates and fixing the level of longer-term yields will continue, despite the Japanese economy far surpassing predictions by growing strongly in quarter two. Suggesting that this was not a flash in the pan, the data continues to beat forecasts.
A breakdown of second-quarter growth reveals strength in the domestic economy – consumption and capital spending were both much stronger than expected while, unusually for Japan, external demand was a modest drag on performance.
Japan’s major companies are currently more confident than they have been for more than a decade, optimism matched by the Organisation for Economic Co-operation and Development leading indicator for Japan while deflation has been avoided for a year. The Japanese economy is on a tear. This has been a long time coming but coming it is – and the full boost of the 2020 Olympics lies ahead.
Over the past three months Japanese equities have comfortably outperformed their American and European counterparts and that outperformance is accelerating. As recent work by UBS highlights, dividends from Japanese companies – currently on a par with those in the US - have been growing at twice the rate of their major international competitors and have historically proved much more resilient.
Given that company earnings in the past year have risen by nearly 15 per cent, the prospect is for payouts to remain healthy. Small wonder that international investors are starting to rebuild weightings in a market they have long ignored.
A few months ago, Shinzo Abe’s popularity had plunged and investors worried that Japan would suffer the political upheaval seen elsewhere. Now Abe looks set to come out of the imminent snap election as the only incumbent politician to have their position reinforced. Worries that Abe-nomics might come to an end are fading fast.
The debate continues around how monetary policy should evolve. Equally unresolved is whether - and how - QE works. In recent weeks equity investors have expressed their views: they’d rather have QE than not. Japan looks well placed to remain the land of the rising equity market.
Stephen Jones is chief investment officer at Kames Capital.
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