It is very interesting from a European or a US perspective to follow what the Bank of Japan does with regard to monetary policy, because the Japanese central bank is often a ‘testing ground’ for the Fed and the ECB. This is mainly because Japan has been battling low growth and the risk of deflation for much longer than the US and Europe.
In September, the Bank of Japan reversed its strategy with regard to monetary policy. There was every reason for this, because after the last time interest rates were reduced and the central bank had started purchasing more bonds and shares, the yen exchange rate increased and share prices declined. This is exactly the opposite of what the central bank intended to achieve. In addition, this easing of monetary policy has not led to far higher growth and/or inflation.
Change in Bank of Japan policy
On 21st September, the Bank of Japan adjusted its policy as follows:
Instead of a fixed amount of bond purchases every month, purchases will now be coordinated in such a way that interest rates on ten-year Japanese government bonds will remain around 0% (bonds with a longer maturity should have positive interest rates). The central bank furthermore intends to get the yield curve as steep as possible. This means that the Bank of Japan will allow itself to be entirely led by market circumstances in its decision regarding how many bonds and with what maturity it will purchase. It does foresee that, for the time being, this will mean the total of bonds that will be purchased will not differ significantly from what has been the case so far. In addition, short-term interest rates will remain at -0.1%.
The inflation target has been increased from 2% to above 2%.
To start with the latter, the Bank of Japan aims to push down real long-term interest rates by lifting inflation. Indeed, this should basically be favourable for asset prices and, moreover, negative interest rates ensure that there is a shift in purchasing power from creditors to debtors. In other words, this is a means of reducing the weight of the debt burden for people who have borrowed money. The only problem is that, despite the fact it is a good plan to increase the inflation target, inflation has remained below the 2% target for years on end. Why would it suddenly exceed this level?
The question is also to what extent it helps the Bank of Japan to keep ten-year interest rates around 0% and keep those with an even longer maturity above this level. One can hardly speak of a steep yield curve now, with short-term interest rates at -0.1% and ten-year interest rates at approximately 0%. The central bank could therefore at least have reduced short-term interest rates further. Indeed, the intention of the steeper yield curve is to make it easier for banks to be profitable, resulting in more credit supply. However, the problem is of course that the further short-term interest rates are reduced, the more difficult it will be to keep interest rates with a maturity above ten years above 0%. This is necessary to ensure matters are not made too difficult for pension funds and insurers.
Ineffective monetary policy needs help from governments
So at first sight the change in policy does not seem to amount to much. This will change drastically once the government applied further fiscal stimulus on a large scale. The government would then have to issue far more bonds to fund this, which would normally push up all interest rates. However, the central bank currently promises it will keep short-term interest rates negative and ten-year interest rates at approximately 0%. This would then require far more extensive purchases by the central bank. Moreover, increasing the public deficit means that the additional money creation ends up almost directly with consumers. It is not a pure form of ‘helicopter money’, but it does come close. Hence, it would also become realistic in this case to assume higher inflation (expectations). The economy would then immediately also receive an extra boost in the form of lower real interest rates.
It is nevertheless only a short while ago that the government presented a fiscal stimulus package. At first sight, this seemed to involve massive amounts, but further inspection of the details revealed the package was actually very disappointing. This is why the financial markets only reacted to this briefly, subsequently dismissing it. Upon the announcement of this package, it was already known that monetary stimulus had lost a great deal of its strength. It was hoped at the time the government would present a robust programme in order to finally drag the economy out of the doldrums. But this ultimately turned out to be very disappointing. This is why the markets are now wondering to what extent the situation has changed in the meantime. That fiscal stimulus was disappointing last time because there was insufficient support to do more (in Japan there are great concerns about public finances spinning out of control, and many economist would prefer to see structural reforms). Are things different now? So far there are only few signs policymakers who have a different view in this regard. So as long as this remains the case, the change in strategy by the Bank of Japan does not exactly represent a sea change.
It is therefore understandable that, for example, USD/JPY initially increased significantly but at the same day fell back even faster. This immediately demonstrates that the initiative should now lie with policymakers. The central bank has made it clear that the old route of monetary stimulus can no longer be used to stimulate the economy. However, if substantial fiscal stimulus were to be applied, monetary policy would be able to add to this. This would enable the central bank to prevent interest rates from increasing, with inflation actually increasing. The resulting lower real interest rates would give the economy an additional boost. So it remains to be seen for the time being whether Japanese policymakers ‘pick up the ball and score’.
End of low volatility period?
In other words, central banks show they remain determined to push up inflation and pressure down real interest rates. However, they need the help of fiscal policy to succeed and central banks do everything to convince governments to do more fiscally. Until now, interest rates and currency markets have been very stable in the past year as most central banks applied a close to zero percent interest rate policy and quantitative easing. But we expect more volatility once governments increase fiscal stimulus measures, as we foresee that the timing and the scale of fiscal stimulus will vary greatly from country to country.
We expect that the new US president (Trump more so than Hillary) will be the first to increase fiscal stimulus substantially. European governments will struggle, as there are great differences in opinion about the best way to stimulate the economy. Germany and other stronger European Monetary Union (EMU) countries favour structural reforms and more fiscal stimulus in countries which, according to the Growth and Stability Pact, have latitude to do so.
The weaker EMU countries prefer much more fiscal policy, either at the national level or at the European level. But Germany will likely oppose this, as more fiscal stimulus at the national level will increase the already high debt levels in the weaker countries, leading to another euro-crisis, while large-scale and debt financed fiscal stimulus at the European level amount to a de facto fiscal union. Without some guarantees that German taxpayers will not be liable for losses on the debt, Germany will likely not approve this. This is negative for the euro and positive for the US dollar. Furthermore, if indeed the new US government is the first to enact large-scale fiscal stimulus, this would have upward pressure on US interest rates and on US economic growth, further increasing the attractiveness of the US dollar.