It’s remarkable how often investors and policy makers focus on the wrong things and are misled. When it comes to monetary policy, obsessive attention is paid to interest rates. By doing so, observers are often wrong-footed. Indeed, monetary policy is all about changes in the money supply, not interest rates.
At present, this “barking up the wrong tree” phenomenon is occurring in Japan where, among other things, the yen just hit a 40-year low.
The widely held view on the Japanese economy over the past few years is that ultra-easy monetary policies, featuring near zero interest rates, have failed to boost spending and resulted in a plethora of economic problems for banks, savers and the government.
Governor Kazuo Ueda, who was appointed to lead the Bank of Japan (BOJ) in April 2023, ended “yield curve control” (YCC) in March 2024, and has been steadily raising its policy rate ever since. He has adopted the theory that wage increases plus higher energy and import prices will ensure sustained inflation and allow Japan to finally hit its inflation target of 2%. Under this theory, the Bank of Japan’s five interest rate hikes since then, from -0.1% to 1%, the highest since 1995, have been warranted.
The problem with this widespread set of beliefs is that they are almost entirely wrong. They all stem from the erroneous idea that low interest rates indicate easy money. On the contrary, in Japan’s case, low interest rates have reflected low money growth, weak economic activity and near deflation over many years. Far from indicating easy money, low rates have been a symptom of tight money — as they have been for many years in, for instance, Switzerland.
A monetarist analysis explains far better what has happened to Japan. From 2000 until the onset of the Covid-19 pandemic in 2020, Japanese broad money (M2) growth averaged a measly 2.6% per year. This generated only 0.3% average nominal GDP, which was split into 0.8% per year real GDP growth and a GDP deflator of -0.5% per year. In addition, there was an annual increase of money holdings of 2.3% per year. And this was despite large-scale “QQE”, Governor Kuroda’s much vaunted version of QE.
During Covid, the BOJ continued with QE, but the real boost to money growth and spending came from the BOJ’s “Fund Provisioning” strategy whereby interest-free (0%) loans were made to banks on condition they on-lent the money to firms. This boosted broad money growth to 9.6% at the peak, finally ending the long spell of deflation.
Exactly as any monetarist would expect, the stock market surged, real GDP recovered, and inflation soared to 4%. In short, monetary policy worked — and in an entirely predictable manner.
However, those conditions no longer prevail. The problem today is that far from persisting with, say, 5% annual broad money growth, Japan has reverted to its pre-Covid policy mix. Prime Minister Sanae Takaichi is boosting fiscal spending while money growth overseen by the BOJ has slumped to 2.5%, a rate that will again produce low nominal GDP growth and near-zero inflation.
The fundamental truth is that interest rates and bond yields are never an appropriate measure of monetary conditions. Rather, they reflect perceived nominal spending growth which in turn is a result of prior broad money growth. Policymakers should focus on the true driver of nominal GDP growth, not on the symptoms.
In Japan’s case, many observers are confused because the lags between changes in M2 growth and changes in nominal GDP are unusually long. This is due to the fact that Japan has experienced very low inflation rates over the past 35 years.
Current bond yields, which tend to track nominal GDP trends, are still reflecting the rise in inflation that occurred during Covid. However, monetary policy, viewed through the lens of M2 growth, is no longer as expansionary as it was during Covid. Indeed, M2 growth has returned to its pre-Covid low growth rates.
Unsurprisingly, overall CPI inflation is slowing, not accelerating. As a result, Japanese bond yields, which have been rising, must, at some point, begin to fall. This is contrary to Governor Kazuo Ueda’s belief that higher wages, energy and import prices will ensure sustained inflation and higher interest rates. Unless M2 growth accelerates to 5% or more, inflation will continue to fall, taking interest rates and bond yields down with it.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
Steve Hanke is a Senior Contributing Columnist at Fortune and a professor of applied economics at The Johns Hopkins University. His most recent book, co-authored with Matt Sekerke, is Making Money Work: How to Rewrite the Rules of Our Financial System, Wiley 2025. John Greenwood is a fellow at the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise.
