On September 21st the Bank of Japan (BOJ) plunged into a mission impossible kind of rebooting its monetary policy framework. The Bank switched to targeting the slope of yield curve, which sounded as if it overhauling more than three years of massive quantitative easing, which did very little to stimulate an economy that was stuck in the doldrums for more than two decades, yet in reality the mechanism to control the yield curve was the same as for the old policy. While Governor Haruhiko Kuroda said the central bank will not hesitate to ease policy further, BOJ did not force the rates further into the negative territory, and announced that it wants to keep rates steady at their current levels, which may indicate a temporary truce in the currency war among the central banks in order to allow a smooth transition of the Chinese renminbi into the SDR reserve currency basket on October 1st. However, the door is left open for the resumption of the war to weaken yen, if the Fed opts out again of the so-called normalisation policy in its December meeting.
The BOJ's press release read:
the Bank decided to introduce "QQE with Yield Curve Control" by strengthening the two previous policy frameworks (...). The new policy framework consists of two major components: the first is "yield curve control" in which the Bank will control short-term and long-term interest rates; and the second is an "inflation-overshooting commitment" in which the Bank commits itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price stability target of 2 percent and stays above the target in a stable manner.The BOJ 's unexpected heterodox move to targeting yield curve, aiming to maintain both the current short-term policy rate and the 10-year Japanese government bonds (JGBs) yield at their current levels of minus 0.1 and about zero per cent respectively, in conjunction with its modified ETFs purchase plan aimed at stimulating investment and growth is fraught with many perils. Not only this adventure would create more market distortions, but also adds to the prevailing uncertainty. In order to mitigate the market anxiety, BOJ offered a nonbinding pledge of maintaining the current pace of the annual increase of about 80 trillion yen ($788 billion), -- which may either be too little or too large for achieving the zero per cent target yield for the 10-year JCB. To wit, they may need to purchase more than the 80 trillion yen or to stop short of it, in order to achieve their target, depending on borrowers' demand.
As for the Bank's inflation target, despite the fact that controlling the slope of the yield curve will most probably alter the transmission mechanism of the monetary policy and will introduce serious unintended consequences, the Bank announced its intention to exceed "the price stability target of 2 per cent", staying "above the target in a stable manner" by the expansion of the monetary base. It is, of course, unclear as how can the BOJ engineer an inflationary process when, as a result of the global slowdown, the economy in all likelihood is heading towards a deep recession.
The desperate idea of controlling the yield curve and challenging the market forces was suggested by the former Fed chair Ben Bernanke who wrote recently in his blog:
The Fed normally operates by influencing very short-term interest rates. However, we know that targeting rates for securities of longer durations is feasible, under some circumstances, since the Fed did it during World War II and the immediate postwar years. (...) Although the Fed’s pegs of 65 years ago were aimed at minimizing the cost of war finance, the same basic tool could be used today to advance the Fed’s macroeconomic objectives.Of course, the investment prospects were quite different from today's conditions of tepid demand and low productivity growth either during the war, when the American economy expanded at an unprecedented rate, war related demands directly consumed over one-third of the output of industry and the surge in productivity stemming from scientific and technological innovation more than doubled the corporate profitability; or in the period immediately after the war, with its the pent up demands, and productivity growth that benefitted from reconstruction activity and commercialization of numerous scientific and technological innovations during the war. Moreover, the idea of manipulating the yield curve appears quite absurd from any theoretical perspectives of the term structure of interest rates, be it the liquidity premium theory, expectations hypothesis, preferred habitat theory, or market segmentation.
In general, yield curve control like any other price control would distort the information content of prices, would generate distributional biases and would exacerbate the current feeble level of capital formation. Ironically, investigating the Operation Twist, launched in early 1961 by the incoming Kennedy Administration, that intended to manipulate the yield curve by raising short-term rates while lowering, or at least not raising, long-term rates, Bernanke, Reinhart, and Sack (2004) argued that if the financial pricing approximates the equilibrium, then trying to target a ceiling on the long-term yields would be successful if those targets were "broadly consistent with investor expectations about the future value of the policy rate." A condition that is hardly satisfied in today's situation of Japan. They wrote:
If investors doubted that rates would be kept low, this view would predict that the central bank would end up owning all or most of the targeted security. Moreover, even if large purchases of, say, a long-dated Treasury security were able to affect the yield on that security, the possibility exists that the yield on that security might become “disconnected” from the rest of the term structure and from private rates, thus reducing the economic impact of the policy.Overall, the authors conclusion was that:
Operation Twist is widely viewed today as having been a failure, largely due to classic work by Modigliani and SutchThus, it is surprising that in his recent commentary about the BOJ's move to yield curve targeting, Mr. Bernanke poses the question "Is the BOJ’s switch to a long-term rate peg a good idea? " and writes:
I think the announcements are good news overall, since they include a recommitment to the goal of ending deflation in Japan and the establishment of a new framework for pursuing that goal. As the BOJ noted explicitly, the Bank will now be able to cut either the short-term rate or its target for the longer-term JGB yield if future policy easing is needed. The follow-through will indeed be crucial: Japan has made significant progress toward ending deflation, but that progress could still be lost if the public questions the BOJ’s commitment to its inflation objective. The commitment to overshoot the inflation target will be constructive if it helps to kill market speculation that the BOJ was contemplating abandoning its fight.Of course, he reiterates his previous argument about the risk of pegging the long-term bond yields, which may cause a central bank's balance sheet to balloon, and states:
That risk is particularly acute if the peg is not credible—if market participants expect the peg to be abandoned in the near term, for example—because then bondholders will have a strong incentive to sell as quickly as possible.Surely, because of its seriously harmful adverse selection effects, it would be most rational for the agents to expect that the peg will be short lived. Thus, it would be hard to imagine that the acute risk identified by Mr. Bernanke would not be materialized.
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| Japan's Evolution of Yield Curves |
It is interesting to note that investors are quite sensitive to the slope of the yield curve. In fact the reason yield curves are informationally rich stems from the ease that bond markets respond to maturity preferences as well as other market conditions. For instance, before the BOJ's announcement, as the above chart demonstrates, concerns over a possible change in the BOJ's monetary policy caused an upward shift in the country's yield curve, as investors worried that the Bank's introduction of more risks along various maturities would cause a decline in their prices, which may also have encouraged a large and abrupt exit of the other bondholders, similarly the downward shift of the curve relative to the end of 2015 was largely related to investors' concerns about the global slowdown after China's stockmarket crash.
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| Japan's Government Bond Yield Curve, Source MarketWatch |
Evidently, the Bank hopes that the link between the impact of interest rates and the shape of the yield curve would change favourably as firms explore new ways of raising funds such as issuing super-long-term corporate bonds, which presumably could offer higher yields to improve the business prospects for pension funds and insurance companies. However, one should not discount the reasonable probability of an steeper yield curve arising from an adverse selection process, whereby the good businesses may judge the new policies as distortionary and thus exit the market, while riskier firms with poorer prospects would be crowded in.
Mr. Kuroda has acknowledged that the BOJ may introduce more fluctuations in the bond market, stating: "Now we have a yield curve control, the amount of bonds we buy could fluctuate." This, of course, would introduce an added source of uncertainty in the market, whereby the participants not only must try to decipher the price signals, but also must now predict the quality of the information of the policy makers and the nature their reaction.
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| Japan's Bank Lending |
It is important to note that, as the above chart shows, despite BOJ's three years of ultra-loose policy the Japanese bank lending has remained stagnant over that period, mainly reflecting the prevailing global uncertainty. It is not clear that a wishful thinking about the ability to target the yield curve or to allow inflation to overshoot its 2 percent target will alter the bank lending, particularly at a time when virtually all central banks' are experiencing a loss of policy effectiveness.
A key factor contributing to the recent lack of capital formation has been the distortionary impacts of BOJ's purchase of ETFs , at an annual rate of around 5.7 trillion yen ($56.12 billion), as part of its QQE program, which have been approximately proportional to the ETF's market values of the three indexes: the Topix, the Nikkei 225 and the JPX Nikkei 400. As well, 300 billion yen of ETFs were committed to "supporting firms proactively investing in physical and human capital". This policy, as a matter of course, would arbitrarily discriminates in favour of the firms that are publicly traded against those that are not, and the criteria of investing in physical and human capital raise the question as what expertise the BOJ possesses in order to assess and select these investment. But apart from such problems, the market was further distorted in favour of those firms registered in the Nikkei index, which is weighted by the price of individual stocks, compared to other indexes, such as the broader Topix, which are weighted by market capitalization.
The BOJ's rebooting aimed at rectifying some of these distortions is utterly vexing. The Bank arbitrarily divides the 5.7 trillion yen into two parts, the first part, which includes a $3.7 million yen would still favour the purchase of the Nikkei-based ETFs over the other two aforementioned indexes. The second part includes the remaining 2.7 trillion yen that would be aimed only at funds tracking the Topix index. It is not clear how these modification would improve the investment climate.
As the chart below demonstrates, despite a lack of productivity growth businesses have added markedly to employment since 2012, indicating that Japanese businesses, like their counterparts in the U.S. and Europe, have also been opting for intensive margin mode of of production, and instead of investing in capital formation were using more labour intensive technologies that would allow a greater use of contingent labour in a highly uncertain post-global-financial-crisis era.
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| Japan's Labour Productivity, and Employment |
The problem is that BOJ's QE policy, implemented over the 2001-06 period, resulted in a drastic shrinkage of Japan's production possibility frontier because of its various distortionary impacts, resulting in a prolonged stagnation of the productivity growth, which has caused the economy to stall. Haphazardly, similar to other central banks, the BOJ attributes its policy ineffectiveness to a fall in the unobservable natural rate of interest, which is supposed to have disguised the insufficient size of the policy accommodation. For Instance, in his 23 May 2016 speech Mr Hiroshi Nakaso, Deputy Governor of the BOJ, has stated that:
Japan's natural rate of interest had been falling due to the decline in the potential growth rate; at the same time, real interest rates remained high due to the zero lower bound on nominal short-term interest rates and the decline in inflation expectations. As a result, QE did not provide sufficiently accommodative financial conditions.A similar reasoning was used by the US Fed's chair, Ms. Yellen who on September 21st invoked the specter of a falling neutral rate of interest, an unobservable variable, as the main reason for why the current ultra-low policy rate is only modestly accommodative, and thus does not justify a September rise in the policy rate, or in her words:
"With the federal funds rate modestly below the neutral rate, the current stance of monetary policy should be viewed as modestly accommodative, which is appropriate to foster further progress toward our objectives,and in the same vein, the ECB president, Mario Draghi, using the term 'real return', defined as ''generated by the balance of saving and investment in the economy", instead of 'neutral' or 'natural' has also used a similar argument in his May 2016 speech:
Over the past decades, however, we have seen long-term yields trending down in real terms as well, independent of the cyclical stance of monetary policy. (...) The forces at play are fairly intuitive: if there is an excess of saving, then savers are competing with each other to find somebody willing to borrow their funds. That will drive interest rates lower. At the same time, if the economic return on investment has fallen, for instance due to lower productivity growth, then entrepreneurs will only be willing to borrow at commensurately lower rates.
As we have argued in various posts in this forum, the Wicksellian natural rate is an equilibrium long-term concept that is irrelevant for the consideration of short term transitory dynamics in getting on toward a new equilibrium. In fact, this theoretical sloppiness causes serious inconsistencies in the arguments of central banks that invoke this excuse. Hence, the whole idea that the unobservable natural rate has declined is a non sequitur argument. In fact, a decline in the potential growth rate would be diminishing the size of the output gap which should be positive for the inflation and inflationary expectations. In a frictionless market the resulting real interest rate decline should induce capital formation and growth. In contrast, when there are uncertainty and policy distortions the investors will wait, producers would shift to intensive margin and therefore any speculation about the latent neutral rate in a disequilibrium state would be absurd.
What caused the Japanese lack of productivity growth, were the slow growth of the 1990- 2005 period and its associated lack of capital formation, resulting in a decline in Japan's growth potential by the second half of the 2000's which was aggravated by the global financial crisis and inappropriate policy responses.The economy contracted severely and the year-on-year rate of consumer price exhibited deflationary tendencies. The decline in the capital formation and a shrinkage of Japan's production possibility frontier triggered a slowdown in Japan's productivity growth.
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| Japan's CPI Inflation and Core Inflation Rates |
As the above chart shows, despite the BoJ’s large QE programme and negative interest rates , which have contributed to pushing the yields on about $13 trillion of government debt globally below zero, the country is now slipping back into deflation.
What about the currency wars? One may speculate, with some reasonable likelihood, that perhaps there were a tacit understanding among the US, Eurozone, Japan and China's authorities, in the recent G20 meetings, that the near recessionary situation in China and the prospects of renminbi devaluation, which on October 1st this year is supposed to become part of the new SDR basket of reserve currency, warrant a relatively less volatile exchange market. Thus, the September inaction by the Fed, the BOJ and the ECB would allow the US dollar not to appreciate and would help to maintain a less volatile currency markets, which would buy some times for the China's monetary authority to deal with the country's economic slowdown. In this regard it is interesting to note that on September 22nd, the spokesman for the IMF, discussing the question of inclusion of renminbi in the SDR has said:
[I]n the last 12 to 18 months there have been a lot of changes in the value of currencies or exchange rates (...) if the underlying currencies are volatile, then the [SDR] basket will move more. It depends on how the currencies move against each other in the periods ahead. (...)
[I]n simple terms we look at the average exchange rate of the basket currency over the last three months that will end on September 30th, and that’s one determiner. The other is that the value of the SDR basket is unchanged as a result of the transition, and from that we can determine what currency amounts using those average exchange rates will give you the rates that the IMF Executive Board has decided. And that can only be determined on September 30th because we are using exchange rates that run all the way through September 30th. So that will be decided on September 30th.
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| US Dollar to Japan's Yen and to China's Yuan Exchange Rate |
To conclude, BOJ's policy shift toward yield targeting would create further economic distortions that would hamper growth. The BOJ may be successful in influencing short-term bond yields into negative yields. But, as Governor Kuroda himself has admitted, negative rates particularly hit the profit of financial institutions, while low long-term yields hurt some other businesses by forcing them to put aside more money for long-term pension obligations. All these indicate that the current truce in the currency war would be a short-lived one.
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| Bank of Japan's Monetary Policy Actions, Source: BOJ |
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