Earlier this week I highlighted five issues that could prove particularly thorny for international economic policymakers this year. They were:
– A further sharp depreciation of the yen, in a scenario where the Bank of Japan needs to double down on quantitative easing (QE) to achieve it’s two percent inflation target.
– A widening of external imbalances notably in Germany and China.
– Market anxiety over the ongoing litigation in Argentina and the ongoing public debate over the rules of the game for debt restructuring.
– The debate triggered by Paul Krugman and Larry Summers among others over whether the United States is suffering from “secular stagnation” that requires extraordinary demand policies to restore full employment.
– The vast number of potentially headline-grabbing emerging market elections that, more than concern about Federal Reserve tapering, will be a focus for investors in those countries.
Of the five, I have received the most push back on the Japan question, where many believe that current stimulative policies and a solid wage round will sustain demand in 2014 and more than offset the increase in the consumption tax this April. I am not so sure. Robbie Feldman of Morgan Stanley, for example, tells a convincing story for QE2, where a loss of political and economic momentum, and the drag from the second (fiscal) and third (structural) arrows pose downside risks for inflation and growth. I am confident that should the expansion and inflation (and inflationary expectations) falter, the Bank of Japan has substantial scope to boost Japanese government asset purchases and extend its forward guidance in order to achieve the two percent target. In a weak domestic demand environment, the exchange rate would be a powerful channel through which that additional stimulus would operate.
How would a yen of 120 or 130 against the dollar play out in the policy debate? Certainly it will create problems for the U.S. Treasury in current Trans-Pacific Partnership (TPP) negotiations, as well as for G20 efforts to limit exchange rate volatility. The broader problem is the risk of competitive measures—devaluation and capital controls—from other countries. So far, capital controls has been the dog that has not barked. But with central bank policies increasingly desynchronized, that could change in 2014.
The U.S. Treasury also needs to move quickly to nominate and have confirmed a new Undersecretary for International Affairs. Lael Brainard stepped down in early November, and the position remains unfilled. This makes it all the more difficult for the U.S. to show the necessary leadership on these issues.