In the world of uncharted monetary policy, Japan has become the leader in exotic policies. They’re further along the easing curve than anyone else and represent a live case study on the limits of central bank intervention.
The BOJ recently made some major changes to how they will institute expansionary monetary policy going forward. It’s worth exploring these changes so that we can better understand their ramifications if and when the time comes for the US to consider following suit.
Over the last few years, Japan’s policy could be characterized as “easing at all costs.” Lower interest rates were deemed the harbinger of aggregate demand, and lower was considered better across the entire yield curve. That’s now changed, as a result of learnings from past experiments.
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In the old days of monetary policy, the primary instrument central banks used to influence the economy was the interest rate on overnight commercial bank deposits. This is still the primary tool in use today, but its effectiveness has waned over time.
While one would be inclined to think that changes in short-rates would impact longer-term rates, recent history has proven that not to be the case. Short rates are controlled almost entirely by central banks, while longer-term rates, such as the yield on 10-year bonds, have been predominantly under the influence of global investors.
In seeking more control over interest rates, especially the longer-term interest rates at which consumers and businesses typically borrow, central banks began the process of quantitative easing.
The goal here was to purchase longer-term debt securities so as to drive their prices up, and resulting interest rates lower. The advent of QE across many developed nations marked a shift in central bank policy, as it represented the intention to control the entire yield curve.
With short-rates already at zero, QE was the next logical step in terms of rate suppression in an attempt to get consumers and businesses to borrow, spend and invest.
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When that failed to spur demand, Japan began the use of negative interest rates. Aimed at penalizing banks for not lending, negative interest rates spread throughout the yield curve, causing maturities up to and beyond 10-years to trade with negative yields.
Then came the complaints of banks, insurance companies, pension funds and savers.
Banks seek to make money on the spread between short-term rates and longer-term rates. Insurance companies, pension funds and savers are simply looking for a safe way to earn a meager return. All of these groups found themselves in a state of despair with long-term Japanese rates below zero.
Enter the next evolution in central bank control: long-term rate targeting.
Previous versions of quantitative easing emphasized the size or quantity of purchases, leaving the ultimate effect on rates as the unknown variable. In a recent shift, Japan has switched that relationship around. Now, they’re setting a rate target on their 10-year bond (of zero percent), and the amount of bond purchases required to achieve that rate will be the unknown variable.
Why the sudden shift?
The move from “easing at all costs,” which implies lower is always better, comes as a result of the ramifications of a flat yield curve.
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With short-term rates and long-term rates nearly identical, banks were being squeezed, unable to make any money on the spread between short and long-term rates. This disincentivized banks to lend because they were bearing additional risk without being compensated.
The new policy of targeting a 0% rate on the 10-year bond is designed to steepen the yield curve, thereby providing an incentive for banks to lend. In theory, pegging the 10-year yield at zero would allow the BOJ to steepen the yield curve by taking short-term rates further into negative territory. And the BOJ hopes that a 10-year yield at zero will imply that rates on even longer maturities are positive, thereby helping insurers, pension plans and savers.
This policy change has some interesting ramifications. First, because the 10-year bond was recently below zero percent, the move to peg it at zero actually implies a reduction in monetary stimulus.
The BOJ’s old target of buying 80 trillion-yen worth of Japanese government bonds was partly responsible for a negative yielding 10-year bond. Since the goal is now to have that rate a bit higher, purchases can be scaled back. This is a good thing especially considering that the BOJ is slowly running out of bonds to buy.
But this move to rate targeting also puts the BOJ in a precarious situation because rate targeting involves potentially unlimited purchases and sales of bonds. The BOJ now must effectively work against global investors and offset their money flows into long-term government bonds.
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Mr. Haruhiko Kuroda, Governor of the Bank of Japan, recently said that controlling the yield curve is “quite doable.” Whether this is truly the case remains to be seen.
The BOJ’s other notable change has to do with their targets for inflation. Scrapping their timetable for bringing inflation back to the 2% target, the BOJ is now aiming to “overshoot” that target as soon as possible.
This notion of overshooting inflation has begun to creep up more frequently in central bank comments across the globe. Even some Fed officials have referenced this idea. The underlying objective seems clear, but is also worrisome.
Years of deflation or below-target inflation means debt has not been “inflated away” at the rate that policy makers would like to see. This means that current debt, of which the world is flooded, is having more of a drag on future consumption than desired.
All the talk of allowing inflation to run hot seems to be geared at playing catch-up for these years in which the debt drag has remained onerous.
Inflation allows an economy to reduce the penalty of previous debt, freeing up funds for future consumption. This “engine” of consumption could play a very important role in the future, if and when we finally see the whites of inflation’s eyes.
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