When European Central Bank president Mario Draghi promised to do “whatever it takes” to save the euro at the end of July last year, the market reaction was instant. After an interest rate rally and sell-off in equity and commodity markets in the second quarter, risk-on came back with a bang. Draghi’s words have since been backed by action, although not from the ECB. First, December’s US Federal Open Market Committee meeting announced an increase in monthly asset purchases from $40 billion to $85 billion. Then, last month, the Bank of Japan slammed the monetary pedal to the metal. To say the BoJ’s announcement beat expectations would be an understatement. The nominal GDP of Japan is roughly 40% of that of the US, yet the BoJ plans asset purchases of ¥7.5 trillion ($70 billion) each month, not far below the target of the Fed.
The Japanese authorities have given themselves licence to buy JGBs of any maturity, exchange traded funds and real estate investment trusts. The stated aim is to engineer 2% inflation. If Milton Friedman was right and inflation is “always and everywhere a monetary phenomenon”, the BoJ might succeed. It is doubling Japan’s monetary base.
Two observations
A study by Citigroup economists last April calculated that an increase in the balance sheet of a central bank by the equivalent of 1% of GDP decreased long-term interest rates by six basis points and translated into an effective overall monetary easing of 23bp. The note added two observations that might have also helped to inform the BoJ’s actions: balance-sheet expansion is most powerful if it is reflected in the monetary base; and easing in Japan had been modest compared with the US and UK.
The Bank of Japan is inflation targeting just as it falls out of fashion elsewhere. But Japan, uniquely, has been trapped in the quicksand of stagnation/deflation for two decades. Reversing that requires aggressive action. In some ways deflationary expectations are even more sticky and insidious than a fear of price rises. No one will rush to buy something today if they expect that it will be cheaper in the future.
This policy is far from risk free, either politically or economically. Japan has a rapidly ageing population and a high savings rate, equal to 7% of GDP. Most of this money is squirrelled away in ultra-conservative money market funds, Japanese government bonds and Japan Post Bank. Pushing bond yields down should force savers out of safe havens and support equity markets and other asset prices.
If Japanese investors started buying abroad, it would also help weaken the yen further. The influence of geopolitics on the viability of this strategy should not be underestimated. The G7 has let a competitive devaluation pass without comment. It seems as though currency wars are not a Hobbesian fight of all against all, so long as you are a bulwark in the Pacific for the US against a newly assertive China.
Will the BoJ’s radicalism work? Chairman Mao’s view on the merits or otherwise of the French Revolution seems the most sensible answer: it is far too early to say. Japanese savings habits and a deflationary psychology have become deeply ingrained. Unless this monetary experiment boosts the real economy quickly and there is a positive wealth effect, a backlash is likely. Many people in Japan are more worried about inflation and negative real interest rates than deflation.
The Fed and Bank of England have a new target too: avoiding deflation. Both seem to have concluded that this is the battle that they must fight. If that feeds into higher inflation in the future, then so be it. The Fed can hide behind the fig leaf of its mandate to ensure full employment. The Bank of England prefers letter writing to a (perhaps) complicit chancellor of the exchequer, who may not be averse to negative real interest rates inflating the UK’s debt away.
New-broom Bank of England governor Mark Carney might choose to sweep the policy prescriptions of the past away entirely. In the meantime, markets are reacting with joy unbound. The MSCI World index is up 20% in dollar terms since Draghi’s speech and Japan’s Nikkei 225 index by 30%. Yen-based investors have enjoyed a 65% rally. Bolivian bond yields are under 5%. Cov-lite loans are back.
Comments from Jeremy Stein to the Federal Reserve Bank of St Louis research symposium in February are worth noting. Stein is a well-respected academic, but perhaps more interestingly, he is also a member of the board of governors of the Fed. His topic was overheating in credit markets. Stein said: “A prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to ‘reach for yield.”’
It is hard to argue that this process is not already well advanced. Monetary shock and awe might yet end up in asset-price schlock and gore. The Fed was the first mover on QE and might be first out. The sanguine state of markets suggests that they are not prepared. Has it only been six years since the last credit bubble? Round and round and round it goes.
Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. He welcomes comments from readers and can be reached at amcapon@btinternet.com