The Bank of Japan is nothing if not innovative. After all,
it was the BoJ which first attempted a policy of quantitative easing in 2001, which
involved buying large amounts of securities in order to flood the economy with
liquidity in a bid to stimulate inflation. Central bankers in the west treated Japanese
QE as an interesting intellectual exercise but never really believed that they
would ever have to implement it. But some eight years later the Fed and BoE
were doing exactly that.
Meanwhile the BoJ has tried everything it knows to raise inflation to 2%, which was a key element in the Abenomics strategy unveiled in early 2013. The BoJ has bought huge quantities of securities and in the process has raised the central bank balance sheet to around 90% of GDP, which is more than three times that of the Fed, ECB or BoE. But buying ever more financial assets is simply not working as inflation remains stuck at extremely low rates.
So the BoJ opted this week for a different tack: Its two-pronged approach seeks to control the yield curve by holding 10-year yields at zero and allowing inflation to overshoot the 2% target. Such an approach differs from the standard QE policy in as much as it fixes the long end of the curve, rather than driving it down. Using the standard levers to control the short end allows the BoJ to steepen the yield curve, and reduce fears that driving down short rates will hurt the banking system. The idea is that the BoJ, which already has a long track record of asset purchases, only needs to tell the market that it has a 0% target and investors will fall into line without the need for a huge rise in central bank purchases. In essence, it will be a cheaper way for the BoJ to hold interest rates down, and if it is successful in stimulating inflation, will push down real interest rates and thereby give real activity a lift. The idea of overshooting the inflation target relies on the argument that more inflation tolerance will be necessary in order to move expectations to be consistent with achieving the 2% target in the first place.
But central banks have long avoided trying to control the longer end of the yield curve, arguing that it is difficult to do so and introduces distortions into asset markets as they seek to fix the benchmark risk-free rate. Indeed, if the market decides to test the BoJ’s resolve, it may end up having to buy a lot more paper than under the current QE policy (which, by the way, will continue to run in parallel). There are other serious flaws in the strategy: The commitment to fixing the 10-year yield means that in the event of a bond market sell-off which prompts a global rise in yields, the BoJ is required to continue expanding its (already large) balance sheet indefinitely. Some analysts have pointed out that the BoJ is relinquishing control of real interest rates whilst policy becomes highly pro-cyclical. For example, if there is a negative demand shock that raises demand for JGBs (i.e. yields fall) and depresses inflation expectations, the BoJ will reduce the amount of JGBs it buys whilst falling inflation expectations put upward pressure on real rates. All in all, given the BoJ’s failure to achieve its policy objectives over the past 20 years, scepticism remains high that this policy will be no more successful than the others.
We also now run the risk of straying into the area of debt monetisation. Balance sheet expansion of the form implied by QE is meant to involve a temporary expansion of the central bank’s asset holdings. The theory is that they are run down over time, otherwise the central bank merely holds assets until such times as they mature and hands the proceeds back to the government. Nowhere are central banks talking about running down balance sheets. In theory, if the BoJ is forced to sell bonds in order to hold nominal yields at zero, this could be one side effect, but the presumption is that balance sheets should rise rather than fall. Continued balance sheet expansion creates all sorts of problems because (a) it raises governmental moral hazard risks and (b) in theory could unleash much more serious inflationary pressures than central banks are aiming for.
Whilst the BoJ’s QE policy in 2001 was an experiment which was copied by other central banks some years later, I seriously hope this is one lesson we don’t copy in Europe (for one thing debt monetisation is prohibited in the euro zone). It looks like a policy of desperation: if flooding markets with liquidity cannot stimulate inflation, I cannot see how yield curve control will. Boosting liquidity leads to higher inflation when it is transformed into the purchase of goods and services. In an ageing society like Japan, where people are content to sit on their money balances, greater liquidity provision will not prove to be the inflation stimulant which the BoJ seeks. I have long maintained that efforts to get Japanese inflation back to 2% without some help from global conditions will not work and I remain sceptical that these measures will do the trick either.
Meanwhile the BoJ has tried everything it knows to raise inflation to 2%, which was a key element in the Abenomics strategy unveiled in early 2013. The BoJ has bought huge quantities of securities and in the process has raised the central bank balance sheet to around 90% of GDP, which is more than three times that of the Fed, ECB or BoE. But buying ever more financial assets is simply not working as inflation remains stuck at extremely low rates.
So the BoJ opted this week for a different tack: Its two-pronged approach seeks to control the yield curve by holding 10-year yields at zero and allowing inflation to overshoot the 2% target. Such an approach differs from the standard QE policy in as much as it fixes the long end of the curve, rather than driving it down. Using the standard levers to control the short end allows the BoJ to steepen the yield curve, and reduce fears that driving down short rates will hurt the banking system. The idea is that the BoJ, which already has a long track record of asset purchases, only needs to tell the market that it has a 0% target and investors will fall into line without the need for a huge rise in central bank purchases. In essence, it will be a cheaper way for the BoJ to hold interest rates down, and if it is successful in stimulating inflation, will push down real interest rates and thereby give real activity a lift. The idea of overshooting the inflation target relies on the argument that more inflation tolerance will be necessary in order to move expectations to be consistent with achieving the 2% target in the first place.
But central banks have long avoided trying to control the longer end of the yield curve, arguing that it is difficult to do so and introduces distortions into asset markets as they seek to fix the benchmark risk-free rate. Indeed, if the market decides to test the BoJ’s resolve, it may end up having to buy a lot more paper than under the current QE policy (which, by the way, will continue to run in parallel). There are other serious flaws in the strategy: The commitment to fixing the 10-year yield means that in the event of a bond market sell-off which prompts a global rise in yields, the BoJ is required to continue expanding its (already large) balance sheet indefinitely. Some analysts have pointed out that the BoJ is relinquishing control of real interest rates whilst policy becomes highly pro-cyclical. For example, if there is a negative demand shock that raises demand for JGBs (i.e. yields fall) and depresses inflation expectations, the BoJ will reduce the amount of JGBs it buys whilst falling inflation expectations put upward pressure on real rates. All in all, given the BoJ’s failure to achieve its policy objectives over the past 20 years, scepticism remains high that this policy will be no more successful than the others.
We also now run the risk of straying into the area of debt monetisation. Balance sheet expansion of the form implied by QE is meant to involve a temporary expansion of the central bank’s asset holdings. The theory is that they are run down over time, otherwise the central bank merely holds assets until such times as they mature and hands the proceeds back to the government. Nowhere are central banks talking about running down balance sheets. In theory, if the BoJ is forced to sell bonds in order to hold nominal yields at zero, this could be one side effect, but the presumption is that balance sheets should rise rather than fall. Continued balance sheet expansion creates all sorts of problems because (a) it raises governmental moral hazard risks and (b) in theory could unleash much more serious inflationary pressures than central banks are aiming for.
Whilst the BoJ’s QE policy in 2001 was an experiment which was copied by other central banks some years later, I seriously hope this is one lesson we don’t copy in Europe (for one thing debt monetisation is prohibited in the euro zone). It looks like a policy of desperation: if flooding markets with liquidity cannot stimulate inflation, I cannot see how yield curve control will. Boosting liquidity leads to higher inflation when it is transformed into the purchase of goods and services. In an ageing society like Japan, where people are content to sit on their money balances, greater liquidity provision will not prove to be the inflation stimulant which the BoJ seeks. I have long maintained that efforts to get Japanese inflation back to 2% without some help from global conditions will not work and I remain sceptical that these measures will do the trick either.
