Credit: Shutterstock photoMarshall Gittler, Head of Investment research, FXPRIMUS.com
The Bank of Japan (BoJ) Friday passed up the chance to increase its monetary stimulus, as many market observers had expected, and instead just tinkered around the edges with some token adjustments. Not only that, but it also called for a review of the impact of its extraordinary monetary policy on economy and said it will debate the issue at the next Monetary Policy Meeting (MPM) on 20-21 Sep.[i]Is Japan, the first country in the world to adopt zero interest rates and quantitative easing, now signaling that monetary policy has reached its limits?
As I pointed out last week, the country hasn’t been particularly successful in changing the trajectory of its economy over the past several decades, although some economists (notably Richard Koo of Nomura) have argued convincingly that things would’ve been much, much worse if they hadn’t acted as they did. With regards to inflation, the Bank of Japan’s raison d’etre, they haven’t hit their 2% target since 1992, except for brief periods when tax increases pushed retail prices up – hardly what one would call a success.
Japan is of course the world leader in experimental monetary policy. It lowered overnight interest rates to 0.5% in 1995 and when that didn’t work, adopted the-then unprecedented Zero Interest Rate Policy (ZIRP) on in February 1999. The policy was rescinded in August 2000 as the economy showed signs of recovering, but it was a false dawn insofar as prices were concerned and the Bank instituted the first quantitative easing (QE) program from March 2001 to March 2006.
The current “quantitative and qualitative easing” (QQE) program dates from April 2013, and the “QQE with a Negative Interest Rate” from January of this year.
Naturally, it has over the years done many reviews of the problems it faces, notably deflation, and evaluated how well its attempts to solve those problems have fared. Its latest review was a little over a year ago, in May 2015.[ii] It concluded that the program was a success.
Although inflation was below target, it attributed that failure mainly to the fall in oil prices and said that “the basic transmission mechanism of QQE’s effects ... can be considered as continuing to operate.”
What is that transmission mechanism? The paper included the following flow chart. Note the central role of inflation expectations. This ties in with BoJ Gov. Kuroda’s “Peter Pan Principle,” which he stated in June 2015. “I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it,’” he told a BoJ conference. “Yes, what we need is a positive attitude and conviction.”
The line of reasoning is as follows: if people think that prices are headed higher, they will demand higher wages. Companies will pay higher wages and then raise their prices to cover those higher wages. Then more people will ask for wage hikes. Result: inflation!
How’s that theory working nowadays? Not so good!
The Economic and Social Research Institute (ESRI), part of the Cabinet Office, asks about price expectations as part of its monthly Consumer Sentiment survey. As you can see in the graph, the percent of people who think prices will be higher in one year (the yellow line) started to increase after PM Abe was elected PM in December 2012 and jumped when QQE began in April of the following year. At the same time, the number of people answering “don’t know” (the bright blue line) fell to the lowest level, indicating confidence in the QQE measures.
Inflation expectations peaked in Feb. 2014, about a year after the introduction of QQE. They fell somewhat after that but took another leg up in anticipation of further moves from the BoJ, which came in Oct. 2014. But since then, expectations of rising prices have diminished considerably, while expectations of deflation or no inflation (the dark blue line) have risen notably. The introduction of negative rates seems only to have hastened the decline in expectations, not stopped it.
So far expectations haven’t returned to where they were before the QQE measures were introduced, but the trend is in that direction.
An additional worry for the BoJ may be that the number of “don’t knows” hasn’t returned to the level it was before QQE was introduced, either. In other words, people are more certain than ever about the inflation outlook, and they’re starting to lose confidence in the BoJ.
Market-based measures tell an even worse story. Market participants expected no inflation or modest deflation before PM Abe was elected, but once he was elected and BoJ Gov. Kuroda nominated, expectations shot up (although they never reached the BoJ’s 2% goal). However, since the middle of last year – coinciding with the second leg down in oil prices – expectations plunged. The introduction of negative rates seems to have stabilized inflation expectations around zero, but barely lifted them.
In short, if the transmission mechanism of QQE relies on creating expectations of inflation – as the BoJ says it does -- then it clearly hasn’t worked. Either they will have to find some new, super-duper way to ease even further, or abandon the whole idea. Personally, I think they’ll have to admit that monetary policy can’t achieve their target and give it up, or adopt some other, more flexible inflation target.
If they decide to double down, then we might be looking at the dreaded “helicopter money” after all. Remember that Gov. Kuroda said he had no plans to adopt negative interest rates just 8 days before he actually did so. (And let’s not even mention the SNB!). In that case, USD/JPY would probably start flying.
On the other hand, if they do decide to give up on QQE, I expect USD/JPY would fall through ¥100. In that case, the MoF might respond by intervening heavily, as it did in 2003/04. That in itself would be a form of quantitative easing. Japanese bond yields would also be likely to rise.
The bigger implication though would be what the impact of the BoJ giving up on monetary easing would be on other central banks. Remember “The moment you doubt whether you can fly, you cease forever to be able to do it.” If the central bank with the longest experience in QE determines that it doesn’t work, then what would the impact be on the ECB? Would they be able to keep rates negative in the face of this change? Or the SNB? How would it affect the BoE’s strategy? (They will probably ease further at their August meeting.) We may be approaching the time of multilateral disarmament among the global central banks and a return to fiscal policy as a major tool of economic stimulus, as the recent G20 meeting suggested.
[i] The relevant passage in the announcement read: As shown in the July 2016 Outlook for Economic Activity and Prices (Outlook Report) released today, there is considerable uncertainty over the outlook for prices against the background of uncertainties surrounding overseas economies and global financial markets. Against this backdrop, with a view to achieving the price stability target of 2 percent at the earliest possible time, the Bank will conduct a comprehensive assessment of the developments in economic activity and prices under "QQE" and "QQE with a Negative Interest Rate" as well as these policy effects at the next MPM. The Chairman instructed the staff to prepare for deliberations at the next meeting.
[ii]Bank of Japan Review: Quantitative and Qualitative Monetary Easing: Assessment of Its Effects in the Two Years since Its Introduction
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
