Inflation and its expectations are anchored in negative territory, interest rates are beginning to rise against forecast and the economy does not finish accelerating. Although the Bank of Japan has gone further than any other central bank, the country is going in the opposite direction from other developed economies. The pandemic has ended up stripping monetary policy and its extraordinary measures.
At the worst possible time for Japan, inflation expectations do not react and interest rates rise despite the measures applied by the central bank. The BoJ, for its acronym in English, has not done anything very different from other institutions, such as the Fed or the ECB, to deal with the effects of the pandemic on the economy: low rates (negative for the ECB and BoJ) and massive purchases. But there are serious nuances.
The central bank of Japan maintains a program of purchases of corporate bonds and commercial paper up to an amount of 20 trillion yen in total (about 158,000 million euros / 193,000 million dollars), unlimited purchase of public debt, rates at -0 , 1% and control of the interest rate curve at 0% for ten-year bonds. No central bank in a developed economy has gone as far as the BoJ, especially with control of the yield curve.
The objective of this measure is to guarantee very low financing costs. It involves buying unlimited debt at the long end of the curve to keep yields stable at a certain level . Today the chief economist of the Institute of International Finance (IFF), Robin Brooks, has put his finger on the wound with two simple graphs that show how the BoJ has the situation out of control.
On the one hand, inflation expectations remain anchored in negative territory. Since the end of last year, the rest of the world has exploded due to the reopening of economies and the prospects that the Federal Reserve was forced to make a move to begin the withdrawal of monetary stimulus, as has already been announced .
On the other hand, real interest rates, when the impact of inflation is discounted, have shot up into positive territory since the hit of the pandemic began in the global economy, while in the euro zone and the US they turned to the it falls after the response of their central banks. In both regions, they have rebounded as inflation accelerated after last year’s historic drop.
“An example of why controlling the yield curve is not a good idea, it blocks nominal rates, but real rates increase when there is an adverse shock,” says the economist. But it is not the only bad news for Japan.
The country dodged a further slide into recession in the second quarter of the year. GDP grew by 0.3% between April and June compared to the previous quarter, resisting the health crisis. The Japanese economy fell 0.9% in the first quarter. Despite maintaining ultra-low rates, consumption remains entrenched as in pre-pandemic times. In mid-July, the Bank of Japan revised down its outlook for GDP growth between April 2021 and March 2022 to 3.8% compared to 4% previously calculated.
“With inflation stagnant at too low a level, zero-rate policy may not be enough to revive the economy,” New York Fed economists Matthew Higgins and Thomas Klitgaard wrote in a prescient article in The Japan Experience. with the control of the yield curve.
The ability of a central bank to control an economy depends, basically, on the management of real rates and, secondly, on inflation expectations. Prices in negative territory leave little room for maneuver for a central bank to develop countercyclical currency when needed.
The lessons of the pandemic crisis leave a clear message. Central banks have found a way to avoid a financial crisis like the one in 2008, but at the cost of increasing the balance sheet and putting a blank check to buy debt and ensure that credit continues to flow into the real economy. But it is not yet clear whether they have reached the limit of monetary policies. It remains to be seen whether economies can function on their own without the support of central banks.
The consequences that Japan is going through with the behavior of inflation and real rates point in that direction. Asset purchases can be unlimited, even cheap financing for the economy can be guaranteed, but there is nothing else to avoid the fall of the cycle or a shock like that of the coronavirus. The BoJ has been testing the limits of monetary policy before anyone else. Inflation began to fall in Japan in the early 1990s after a rampant crisis triggered by a financial and housing bubble.
In 1994, core inflation, a measure that excludes fresh food and energy prices, was below 1%. The BoJ applied aggressive rate cuts. By 1995, rates had been slashed to 0.5%, an unprecedented level at the time. At the end of 1999, the policy rate was reduced to zero, but the CPI fell to 1% per year between 1999 and 2002.
It was the first central bank to launch Quantitative Easing , a debt purchase program. The first to accept in assets beyond government debt, including ETFs and stocks. And the one in charge of unearthing control of the interest rate curve, a monetary policy tool applied in times of war. The Fed used it during World War II to finance the contest.
In April 2013, the BoJ adopted the strategy of “shock and awe”, the first attempt to control the curve. Added to his QE was a commitment to buy bonds to flatten the long-term yield curve to raise inflation. Three years later, the target of 0% was set for the ten-year bond. Japan achieved two years of interest stabilization that allowed the BoJ to propose reduction in asset purchases.
Economists at the New York Fed are somewhat more lenient with the BoJ when it comes to analyzing the effort to lift Japan’s economy out of deflation. “The challenge for the Bank of Japan is that persistently low inflation expectations are entrenched, but markets were already flooded with liquidity and long-term rates were already close to zero,” they explain, then adding that “the QE alone should have had the power to drive inflation and we also don’t know what inflation would have been without control of the curve. “
Without covid and with the labor market in full employment, inflation should have reacted, according to experts. But the pandemic is showing that the BoJ was already disarmed.