Yesterday saw something of a retracement in equity markets as the Dow Jones Industrial Average fell some 78 points to 10,751 with the fall mostly caused by a downgrade for Microsoft profits. This means that this mornings rally in the Nikkei 225 equity index of some 137 points to 9518 has made a substantial dent in the spread between the two indices which has now fallen to 1233 some 200 points narrower than yesterday. The rally in Japan was caused by some policy action by the Bank of Japan which was overall a surprise.
What has the Bank of Japan done?
There had been some debate ahead of the Bank of Japan’s meeting as to what it might do, usually followed by a debate about what it can do! For those who do not follow Japan the second part of the sentence is caused by the fact that in its long struggle with the “lost decade” in Japan the Bank of Japan has tried virtually everything often more than once. However this morning we got three main announcements.
In a unanimous vote, the Bank of Japan’s nine-member policy board set its overnight call rate target to a range of zero to 0.1 percent. The central bank had not changed the rate since December 2008, when it was set at 0.1 percent. In addition it stated that it would look at establishing a temporary 5-trillion-yen ($60 billion) fund to purchase various financial assets such as government securities, commercial paper and corporate bonds in an attempt to stimulate the economy by lowering longer-term interest rates or what are more commonly called asset purchases or Quantitative Easing. The central bank will offer another 30 trillion yen ($359 billion) through its loan program. This programme which provides cheap loans to financial institutions has been expanded several times now since its inception.
Why has it done this?
“Although Japan’s economy still shows signs of a moderate recovery, the pace of recovery is slowing down partly due to the slowdown in overseas economies and the effects of the yen’s appreciation on business sentiment,”
So the Bank of Japan is concerned about the slowdown in the Japanese economy which has recently become apparent. It may also have been concerned by the way that the Yen had remained strong versus the US dollar even after its currency intervention and so this policy may also be looking to weaken the Yen’s exchange rate. In addition we have had a sign of one of my themes that of reduced or even non-existent central bank independence as Your Party, an opposition group, plans to submit a bill in the Diet session running through December that would give the government a greater role in Bank Of Japan policymaking. There has been talk of such a policy from members of Naoto Kan’s ruling party as well so political pressure may well have played its part in these moves. In this sense the Bank of Japan may well be fighting for its life.
In the battle of realpolitik I do have one thought. If the politician’s do succeed in getting full control over the Bank of Japan who will they have to blame if (some might say when) things go wrong? If I was Governor of the Bank of Japan I would feel that pointing this fact out would be my strongest defence. Again for those who have not followed the situation recent economic policy in Japan has become something of a blame game with politicians blaming the central bank and the central bank blaming politicians.
Will it work?
We have here one of the policy options that Ben Bernanke mused over in his speech at Jackson Hole back in August that of reducing interest rates to zero. It escaped me at the time exactly what good would come from this when rates were already so low. In Japan the maximum move is 0.1% from 0.1 to zero. In a country where interest rates have been so low for so long the effect is going to be very small if one can be measured at all. This type of ZIRP or Zero Interest Rate Policy has not had the effects that its proponents expected and has led to some suggesting that we now need a NIRP or Negative Interest Rate Policy. Fortunately Japan has not tried this as to be frank it sounds more than a little desperate to me.
If we examine the prospect of some new asset purchases by the Bank of Japan any effect is likely to be small. You see such a policy is used to reduce long-term interest rates to hopefully stimulate the economy. However Japanese long-term interest rates are already much lower than anywhere else. For example her ten-year government bond yield fell yesterday from 0.95% to 0.9% which if it was going to do much good the falls in the past to 0.95% should have done so should they not? Japanese 30 year government bond yields are only 1.79%. As I have reported in the past in the section I have on the Japanese economic crisis one of the main weapons of QE has done little good and looking further afield I feel that it is a lesson other policymakers should have learned from. In effect this is part of my critique of Adam Posen’s recent speech that I published here on the 29th September as I feel he needs to explain why he feels that the results will be different this time if he is allowed to set sail on the good ship QE2.
As to the loan plan well that has been modified several times by the Bank of Japan and the modifications have not been because it has been working well! In essence this performs the role of something to announce rather than a policy option which anybody actually believes in.
As you can see from my analysis so far these moves are unlikely to have a direct impact of any great size on the Japanese economy however I do not believe that the rally in Japan’s equity market was entirely misplaced. This is because there will be some indirect effects. For example if we look at the exchange rate of the Yen we see that it has weakened this morning against the Euro to 114.81. Unfortunately it hasn’t moved much against the US dollar or to be more specific after a fall it is already back to where it started. However this is a very muddy area as the US dollar is weak at this time due to the fact that many expect it to introduce more Quantitative Easing itself so it is hard to figure out any trend from the data as there are some many cross-currents. I wrote on this subject on the 23rd and 29th of September and one of the questions I posed, Are we repeating the mistakes of the 1930s? Comes to mind again.
In addition with Japan still mired in disinflation with prices falling and negative inflation being reported for some 20 months now it is possible that one of the side-effects of Quantitative Easing an increase in inflation may actually be welcome in Japan. I have some further thoughts on this subject from the Shadow Monetary Policy Committee in the UK which meets under the auspices of the Institute of Economic Affairs.
The Shadow Monetary Policy Committee
This meets each month usually on the weekend before the actual MPC meets and gives it policy pronouncements. Let me first say that it voted 6-3 on interest rates with the majority voting for no change and the dissenting 3 voting for a rise to 1% because they were concerned about inflation. However something else caught my eye.
Finally, virtually all the SMPC members, including most of the rate hikers wanted a second round of Quantitative Easing (QE), with a further £50bn of asset purchases being the most widely recommended figure.
This was an interesting view because few actually expect any change this week from the Monetary Policy Committee on Thursday but its shadow was almost unanimous on expanding Quantitative Easing. With the Bank of Japan planning a move as discussed earlier this could become a worldwide trend particularly if the Federal Reserve joins in too at its policy meeting on the 2nd and 3rd of November. However the views of one of the members Andrew Lilico attracted my attention and the emphasis is mine.
Critics suggest that printing additional money at this stage would: (a) threaten the Bank of England inflation target’s credibility, given that CPI inflation is well above target and has been so for most of the past four years; and (b) would be inflationary down the line. But the appropriate response to point (a) is that the Bank’s inflation target has no credibility to lose.
Indeed he goes on to suggest that creating inflation is an outright objective of Quantitative Easing.
The response to charge (b), that more QE will be inflationary, is ‘you are quite correct – that is the idea’…………There will be a modest inflationary price to pay on exit – perhaps annual CPI inflation will reach 6% and RPI inflation might reach 10%. But that is a problem for 2012 or 2013.
At least he is being honest but I would challenge his definition of the word “modest”. Also if you look at UK economic history increases in inflation on such a scale are usually very hard to get rid of and at times have led to considerable inflation overshoots as inflationary expectations have become entrenched. These overshoots have often required quite severe measures to remove them. As you can imagine this is a policy prescription which fills me with trepidation as we are supposed to be in a recovery not running the risk of having to tighten again. To my mind this type of strategy could turn out to be one of the worst examples of “kicking the can down the road”. If nothing else his 2012 and 2013 means he can’t even kick it very far!
Finally we get his view on the inflation target.
Meeting the inflation target has clearly not been a key driver of policy since the financial crisis began. It is an irrelevance.
Seeing as the job of the Monetary Policy Committee is to hit the inflation target one might reasonably wonder what Mr.Lilico thinks he is supposed to be doing. It appears that he thinks he can do more or less what he likes and my purpose in introducing this section is duofold. It gives us a possible insight into the announcement today made by the Bank of Japan but also is likely to be representing the views of some members of our own Monetary Policy Committee.
It appears that the view that inflation can easily be controlled if it occurs has become somewhat entrenched in our country’s economic community and in particular in those that have the power to influence events. I suspect that Mr.Lilico is advancing a view that actual members of the MPC have kept quiet. It is not my view that inflation is out of control yet but it has consistently overshot its target in recent times and there are other dangers than deflation awaiting us as we move forward. I have before discussed the alternative of stagflation for example. I would like to repeat my statement from my analysis of Adam Posen’s speech.
Also I have a further thought and it does indicate quite a change. As the role of the Monetary Policy Committee has changed and expanded more than could have been forecast when it was introduced in 1997 there need to be new checks and balances on its power. My suggestion for a change is that MPC members should stand for election as they are currently much more powerful than many of our elected representatives.
I sent this suggestion to my Member of Parliament and will let you know if she gives me the courtesy of a reply. I got a favourable response on the economists and analysis section in the Financial Times.
QE and The European Central Bank
As today has been QE day I can finish off by saying that we now have a concrete reason why the peripheral government bonds in the Euro zone have been rallying. The ECB has announced that it spent some 1.384 billion Euro’s on such purchases last week. This means that in total the Securities Markets Programme has spent some 63.5 billion Euros on such purchases since it was announced on May 10th. One needs to be slightly careful in saying that purchases on the week rose tenfold as the numbers record settled trades and the ECB may sometimes delay settlement to confuse us. But the trend is clear and the rumours of purchases of Irish government bonds look ss if they were true.This puts a slightly different slant on the improvement.