The overhaul of the Bank of Japan’s monetary policy framework at its September meeting marks the latest in a long line of innovations made by the world’s major central banks in the years since the financial crisis. No one can rightly accuse central banks of being short on ideas to stimulate their economies and raise inflation, although many still do! But markets are questioning whether any of this will actually succeed in raising inflation – and whether, in the meantime, monetary policy will do more harm than good. If central banks continue to act without the support of fiscal policy and structural reform, those concerns look justified.
Investors are still digesting the significance of the Bank of Japan’s (BoJ’s) September policy meeting – but on the whole, the market reaction has been underwhelming. The yield on 10-year Japanese government bonds (JGBs) initially increased, but then fell to the level prior to the meeting; the yen initially depreciated before recovering; Japanese equity prices initially increased, but soon gave up some of those gains; and 10-year breakeven inflation (the inflation rate that investors expect to prevail, on average, over the next 10 years) has increased, but only very marginally, from 0.25% to around 0.3% at the time of writing. That’s a long way short of the BoJ’s inflation target of 2%. In sum, these market moves imply that there is little belief among investors that the BoJ’s latest action will be successful in helping Japan escape 14 years of below-target inflation.
The sceptical reaction in financial markets may stem from the fact that the BoJ made little change to its monetary policy stance. The interest rate on excess reserves was left unchanged at -0.1%; the pace of JGB purchases to expand the money supply (i.e. quantitative easing) was held steady at ¥80 trillion per month; and only purchases in the equity market were increased, from ¥3 trillion to ¥6 trillion per month.But this hides a significant overhaul of the BoJ’s monetary policy framework. The BoJ introduced two important changes. First, it made an “inflation overshooting commitment” – the BoJ will continue to purchase JGBs “until the year-on-year rate of increase in the observed consumer price index exceeds the price stability target of 2% and stays above the target in a stable manner”. In other words, the BoJ has taken the first step towards raising its inflation target – a measure that could boost inflation expectations and, in turn, realised inflation. Second, the BoJ will “purchase JGBs so that 10-year JGB yields will remain more or less at the current level (around 0%)”. In other words, the BoJ will now set both short-term and long-term interest rates, in effect controlling the yield curve.
The BoJ looks set to build on these changes by altering its monetary policy stance again in the future. We expect the BoJ to cut the interest rate on excess reserves further during 2016, from -0.1% now to perhaps -0.2% by year-end. This would have the dual virtue of both loosening monetary policy and, with the BoJ targeting 10-year JGB yields of 0%, potentially steepening the yield curve, which should increase banks’ net interest margins. Meanwhile, there has been much speculation among investors that by targeting a particular yield on 10-year JGBs, the BoJ is laying the groundwork to purchase fewer of them. Theoretically, however, the BoJ’s commitment to a particular yield on JGBs commits it to buying any quantity required to bring about that yield. If the BoJ’s commitment is seen as credible, it may not have to buy any JGBs to achieve its yield target. But if the commitment is tested by the market, it may have to buy JGBs in unlimited quantity.
A long line of innovations
More broadly, the BoJ’s actions represent only the latest in a long line of innovations by the world’s major central banks. Quantitative easing (purchasing government bonds); qualitative easing (expanding the scope of purchases to include corporate bonds, equities, and other assets); forward guidance (committing to keep interest rates at a particular level until the economy improves); negative interest rates; tiered interest rates; subsidised lending schemes (providing cheap credit to banks); and now yield curve control, were previously little-used, or outright unthinkable, tools of monetary policy. The chart below shows our assessment of the bias of the world’s major central banks to deploy these policy tools over the foreseeable future.
With the notable exception of the US Federal Reserve, we think that the world’s major central banks are biased towards keeping monetary policy at its current accommodative setting, or loosening monetary policy further. Despite this easing bias, however, in Japan and elsewhere, investors expect the major central banks to fail to achieve their inflation targets over the foreseeable future. Moreover, despite innovations like tiered interest rates, subsidised lending, and yield curve control – all of which are intended to protect banking sector profitability in the face of very low or even negative interest rates – investors are increasingly concerned about the effects of loose monetary policy on the health of banks.
The unintended consequences of extraordinary monetary policy easing are starting to build.
So long as monetary policy continues without the support of looser fiscal policy and much-need structural economic reforms, these concerns look justified. It has become increasingly clear during this period of unprecedented central bank innovation that, despite their best efforts, they cannot do it alone. Moreover, the unintended consequences of extraordinary monetary policy easing are starting to build – in asset price distortions, in financial market risk taking, and in banking sector profitability. However, it is a mistake to lay the blame for these developments at the foot of central bankers: at least they have been trying.
Economists have long argued that fiscal policy has a crucial role to play in periods of insufficient aggregate demand. Now it is the turn of politicians and electorates to remember this important lesson of macroeconomics.
By Paul Diggle, Economist – Investment Solutions. This article originally appeared on the Aberdeen Assest Management ‘Thinking Aloud’ blog on 7th October 2016