Monthly Archives: September 2016

Losing Credibility – Japan’s Central Bank

The central bank of Japan headquarters in TokyoWith the latest Federal Reserve meeting and subsequent announcement last week that interest rates will not be raised at this time, many missed the news from the Bank of Japan. The central bank of Japan not only unveiled a new monetary policy experiment, but also admitted it’s current plans thus far have not worked and that it’s losing credibility.

From Influencing to Manipulating

By now, almost everyone understands that central bank policies push short-term interest rates lower, even though these policies are prompted by a desire to spur borrowing, increase hiring by businesses and boost spending in an effort to increase wealth in a “virtuous circle” that jumpstarts the economy.

The Bank of Japan has been trying particularly hard to shovel money into the economy, not only to spur activity but also to combat deflation. The bank fears falling prices will lead to consumers resisting spending and businesses becoming too risk-averse. As we have noted here before, both of these theories – jumpstarting an economy with money-printing and fearing deflation – are wrong.

Japan Doubles Down on Failure

However, instead of realizing this, the Bank of Japan continues to double down on failure. On Wednesday last week, the bank unveiled a new experiment. Rather than announcing it would inject a certain amount of money into the economy, such as buying a predetermined amount of bonds, it will instead target long-term interest rates directly.

Specifically, the central bank will target the 10-year government bond yield to be zero percent. This means the Bank of Japan will stand ready to buy or sell 10-year bonds so the yield stays near zero. Let that concept sink in for a moment.

Interest rates are important price signals in any economy. Simply stated, they are the price to borrow money. Even more crucially, they coordinate people’s time preference; in other words, they coordinate resources between people who need them now, versus those who want to use them later.

Any institution claiming they know what a price should be, while interfering with the natural free market process of price-setting, is bound to run into trouble. Governments and central banks have tried to control prices of goods before, always resulting in a market shortage or surplus since the price is not left alone to freely coordinate supply and demand.

In this case, the Bank of Japan is setting a hard price on government loans. Japan is one of the most heavily indebted countries on the planet at over 200% debt-to-GDP. If investors ever lose confidence in Japan to pay back this debt, or do so in its own currency, they will sell the bonds, driving up the yields. The central bank will then have to stand ready to buy up all of these bonds to keep the yield at zero, effectively monetizing its debt.

Losing Credibility

Haruhiko Kuroda, the Governor of the Bank of Japan, in a speech accompanying the new policy announcement, noted their 2% inflation target was obviously not working. The bank’s former plan had been to make a strong verbal commitment to a 2% inflation target, and back it up with the bank’s large asset purchases (their QE), hoping they should then see inflation move towards their goal.

Instead, prices continue to fall in Japan. Mr. Kuroda concluded that the plan is not working, theorizing that consumers base their inflation expectations on past prices and psychology, rather than what central bankers tell them.

Too Late

Unfortunately, rather than admit defeat and recognize the limits of centrally-planned monetary policy, the Bank of Japan will continue to pursue any and all policies, ever bolder and more absurd, until it sees the consumer price inflation it desires.

Japanese currency with the text, YENBut higher consumer prices due to monetary policy will not generate more wealth and economic prosperity for Japan. By the time prices rise above their 2% target, it will likely be too late, because confidence in the central bank’s control and the country’s currency will have already been eroded.

The Bank of Japan has frequently been at the leading edge of new monetary policies and experiments, such as negative interest rates and now direct and blatant manipulation of the yield curve. Expect other central banks to watch closely and to try similar measures soon.