Bank of Japan, inexhaustible source of global liquidity

The Bank of Japan was the first major central bank to launch an unconventional monetary policy in the 1990s. In the choice of its policy instruments, the Bank of Japan has gone much further than its US and European counterparts. Nevertheless, it will not reach its inflation target of 2% for a long time to come. Consequently, there is no end in sight to the current extreme monetary policies. The Bank of Japan will, therefore, be the only one to pursue such a policy when the ECB phases out its asset purchasing programme in the near future. Japanese monetary policy has an impact not only on the domestic economy, but also on the rest of the world economy. As a result of the Bank of Japan’s policies, global liquidity creation will be considerable for some time to come.

More and more extreme innovations

We can call the Japanese Central Bank the ‘inventor’ of zero interest rate policy, and then of large-scale quantitative policy. In summary, in the early 1990s it drastically cut its policy rate in response to the Japanese economic crisis. This quickly led, for the first time, to a zero interest rate policy on the part of a large central bank. In the end, the policy rate even became negative. After interest rates were exhausted as an effective instrument, the Bank of Japan launched quantitative purchase programmes. In 2013, this developed into the concept of ‘Quantitative and Qualitative Easing (QQE)’. The emphasis was not only on a more accommodating quantitative policy through the expansion of the central bank’s balance sheet. This also included the ‘easing’ of the quality of the financial assets purchased. After all, the Bank of Japan not only buys government bonds, but also, among other things, more risky equity and real estate funds. Finally, in 2016 the Bank of Japan expanded its QQE policy to include so-called ‘Yield Curve Control (YCC)’. Since then, the central bank has aimed for a 10-year government interest rate of around 0%. Since it already determines the short end of the interest rate curve via its policy rate, the Bank of Japan, in its current policy framework, gains control of the entire interest rate curve up to a maturity of 10 years.

Free market set aside

n the QQE with YCC framework, the Bank of Japan goes further than the US Federal Reserve, the ECB and the Bank of England have ever gone. In doing so, the Bank of Japan not only controls the money market, but also the bond market with maturities of up to 10 years. In concrete terms, the central bank aims for a flat yield curve. After all, the policy rate is -0.1%, while the target for the ten-year interest rate is 0%. The Bank of Japan is ready to intervene in the market with any amount required to achieve this goal. In practice, it believes that, on average, these interventions will have an equivalent value of around USD 60 billion per month. This has an impact not only on the domestic economy via a low and flat interest rate curve, but also on the global monetary environment. Indeed, net liquidity creation on a global scale will remain positive for the time being, despite the Fed’s reduction of its balance sheet and the possible phasing out of the ECB’s purchasing programme in the near future.

Is such a YCC policy also a good idea for other central banks? In any case, the Fed thought about it before the Bank of Japan in 2010 (and rejected the idea). There are a number of obvious advantages to this policy. It has an immediate dampening effect on long-term interest rates. Moreover, if the announcement is credible for the market, the effective interventions necessary to achieve the desired bond yield level may remain limited.

There are, however, a few caveats concerning this. The ten-year rate becomes a real additional ‘policy rate’, which the central bank regularly has to decide on again. Moreover, it is likely to create a high degree of volatility in the central bank’s balance sheet, over which it has little control. Finally, there is the question of the exit strategy. How do you ever get out of such a policy again? Going on forever cannot be the plan, because the disciplining market effect is completely sidelined in both the money and the bond markets. In the case of the euro area and the ECB, a major moral hazard problem would be added if the ECB started to pursue certain levels of intra-EMU interest rate differentials. It would undoubtedly quickly put an end to budgetary discipline in the euro area. It is therefore no surprise that this policy strategy did not seem to be a good idea either for the Fed or for the ECB.

Inflation target 2%, or a bit more?

A second noteworthy objective of the current Japanese policy framework is to have inflation exceed the 2% target for an extended period. In conceptual terms, too, the Bank of Japan goes further than its colleagues. At first glance, it may seem a little strange to try to exceed one’s own inflation target for an extended period. However, it is inspired by the concept of a price level target, which was also discussed by economists in Europe and the US. In summary, this concept implies that the central bank directs its policy towards the level of consumer prices rather than towards annual inflation rates. In other words, the target annual inflation rate should not be a fixed rate for each future year but, if necessary, higher in order to compensate for earlier lower inflation rates. This policy approach can be confusing for financial markets. Indeed, the central bank’s inflation target for a given year is less clear. This could undermine the credibility of the central bank and destabilise inflation expectations. For this reason, among others, none of the other major central banks has ever seriously considered this policy option.

Lessons

Despite all the policy measures taken, the Bank of Japan appears to be unable to raise inflation sustainably. Inflation expectations in the region of 0% appear to be deeply rooted in the Japanese economy. After almost three decades, they have become a self-confirming prophecy, partly via the wage formation channel.

However, to the extent that low inflation is widely expected and largely reflected in price and wage setting, the distortionary impact on the real economy is rather limited. This is clearly reflected in Japan’s favourable growth and labour market performance. Thus, Japan’s situation illustrates the long-term neutrality of monetary variables (including inflation) for the path of the real economy.

The Japanese monetary adventure also shows that unconventional policies can in some cases be maintained on a quasi-permanent basis, without disruptive effects on the real economy or exploding inflation. The latter is also the other side of the coin: quantitative easing is not a sufficient condition for a central bank to achieve its inflation target. The ECB can testify to this.

The line between the Bank of Japan’s monetary policy and fiscal policy has also faded. Some 40% of Japan’s public debt is now on its balance sheet. Monetary policy has thus, to put it mildly, the welcome side effect of contributing to the sustainability of Japan’s skyrocketing public debt (236% of GDP). The determination to keep 10-year government interest rates around 0% also fits in with this picture. This monetary financing of public debt has so far not led to rising inflation; on the contrary. However, this will probably not remain the case forever. So, the Bank of Japan is certainly not a role model for other central banks.

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