The Wrong Diagnosis For Japan

How the Bank of Japan is administering the wrong cure

Originally published in the October 2016 issue

Central bankers find themselves today in an unenviable position. They have succeeded in bringing real interest rates down to historical lows, but struggled to spur demand for loans. They have been hung out to dry by fiscal policymakers, who lack either the political will or capital to engage in expansionary policy. And the negative unintended (or accepted) consequences of their policies are rising and helping to fuel a populist backlash in much of the developed world.

It was against this backdrop that the Bank of Japan (BoJ) altered its stimulus programme in September, after concluding a ‘comprehensive assessment’ of its monetary easing. But instead of charting a new path for major central banks to follow, the BoJ largely misdiagnosed the reasons for Japan’s weak inflationary pressures and failed to administer – or recommend – the correct policy response.

The central bank shifted the focus of its stimulus from expanding the money supply to controlling interest rates by keeping interest rates at -0.10% but introduced an operating target for the 10-year Japanese government bond (JGB) yield at current levels of around zero.

In addition, the central bank removed the maturity target and pledged to keep its asset purchases at about 80 trillion yen annually. The BoJ also promised that policy would now be ‘backward-looking,’ allowing ‘core core’ inflation (CPI excluding food and energy) to exceed the 2% target before it tightened policy.

These are measures designed to keep everyone happy and limit volatility: steepening the front-end of yield curves to support bank profitability; fostering higher long-end yields to help insurance and pension companies offset their liabilities; and committing to buy assets at the same clip to reassure investors it is not running out of ammunition.

Unwilling borrowers
Unfortunately, the BoJ has largely failed to deal with the underlying causes of Japan’s weak inflation and growth outlook.

Japanese consumers and businesses have been net savers for many years not because the price of money is too high – borrowing rates have been low for decades. The real reason for their aversion to borrowing for spending and investment is that they are either concerned about aggregate demand and/or are still trying to reduce their levels of debt after years of sub-par nominal GDP growth. As the economist Paul Samuelson says, ‘You can lead a horse to water, but you can’t make him drink.’

The market reaction to the BoJ’s decision has been, therefore, unsurprisingly underwhelming, with inflation breakevens, stocks and the yen remaining in recent ranges.

In the monetary guardian’s defence, there is little it can do to change aggregate demand due to the diminishing returns of quantitative easing when yields are this low. Aggressive easing in an economy that appears to suffer from ‘secular stagnation’ is likely just to create asset bubbles, while rhetoric is less effective when you have missed your inflation target over a long period.

But there is no excuse for the central bank’s failure to identify the root causes of Japan’s inflation malaise and push for the correct policy response more forcefully.

The BoJ’s ‘Comprehensive Assessment’ listed three primary reasons behind the central bank’s inability to reach its inflation target since introducing ‘Qualitative and Quantitative Easing,’ its aggressive asset-purchase programme, in early 2014: (i) oil price declines; (ii) a hike in Japan’s consumption tax; and (iii) the slowdown in emerging markets.

There is some merit to these arguments, but cynics would suggest that a central bank will always manage to find an exogenous factor to explain any failure. There is also no discussion on correlation and causation; for example, perhaps oil prices fell and emerging markets struggled because of developed market policymakers’ inability to stimulate growth and inflation?

Still, the real disappointment comes from the lack of focus on the endogenous demand side of the equation. The factors mentioned above are not enough to explain continued high saving rates and why the private sector does not want to borrow or invest, despite the rapid expansion of Japan’s monetary base.

In fact, high private sector savings due to structural factors – including challenges posed by Japan’s demography and labour – explain persistent deflationary pressure better than transitory, exogenous variables.

Given that the Bank of Japan is following a well-trodden path, the policy probably will not be a game-changer for investors in the near-term, with currency and equity markets likely to be more reactive to events outside of Japan.

Yield targets and tapering
Meanwhile, there is no reason to doubt the BoJ’s capacity to maintain its yield target, although there are design flaws in the policy if the central bank wants to maintain purchases at their current pace.

In a ‘risk-off’ bond market rally, the BoJ could find itself tapering asset purchases as the 10-year yield falls far below its target, unless it is prepared to accept very flat curves. And in a ‘risk-on’ environment, the central bank could be forced to expand its balance sheet by purchasing JGBs to prevent yields from rising above the target. Ultimately, this is a reminder to investors that central banksare unlikely to buy assets at such a pace indefinitely – and asset allocation decisions should not be made on the expectation that they continue to do so.

We see only two ways in which the BoJ will be able to hit its inflation target: if stronger US growth triggers yen weakness and an increase in import prices; or if the central bank works with the Japanese government to fund fiscal expansion, albeit implicitly.

If these scenarios do not occur, the market will be left in an endless game of ‘carry chicken.’ The BoJ will drive down JGB yields, while the private sector will seek carry in foreign assets until central banks tacitly admit that the costs of expanding their balance sheets outweigh the benefits. The timing of this is highly uncertain.

The policy of capping rates can only be expan-sionary in its own right if the interest rate is held below the market rate, which is not currently the case. The Great Depression did not end simply because the US capped rates, but because rates were held below their natural level amid the fiscal stimulus of the New Deal and the Second World War. If there is no fresh fiscal stimulus, then we are left in the same situation where monetary policy only serves to distort asset markets and the Japanese economy is at the mercy of the external environment.