Recently, fears for an “European Japanification” have regained popularity due to raising concerns about the growth’s slowdown and similar underlying long-term dynamics of the two economies. In this article we aim to walk through Japan’s “Lost Decades”, and the following Bank of Japan’s response to figure out monetary tools, beyond central bank traditional repertoire, that may be employed when the next downturn hits.
The lost decades
Japan “Two Lost Decades” is a period of economic stagnation and growth running below potential which lasted from the bursting of Japanese stock and real estate bubble in 1991 to the recent US global financial crisis in 2007.
Japan experienced a strong phase of economic growth after the Second World War thanks to many structural factors and to its capitalist system where government support played a key role until the 90’s: the MITI, “Ministry of International Trade and Industry”, led much of the industrial policy of post-war Japan supporting the development of Japanese industrial base. In the meantime, Japanese companies could focus on building market share, rather than on profitability. This was possible as they are organized through so-called “Keiretsu”: large group of interconnected businesses which operate in related fields and own each other’s shares, generally built around a bank lending to the affiliated companies. On one hand, Keiretsu allowed companies to focus on long term growth, on the other they made the economy very reliant on bank’s support, as companies did not need to raise funds through public markets.
Then, with the worldwide financial deregulation of the 1980’s, Japanese banks lent more, and this led to a general deterioration in credit standards. This process was exacerbated in Japan because the Bank of Japan stimulated lending through an unofficial regulatory tool called “Window guidance”: the BoJ could choose the overall increase in bank lending for the economy and then set loan growth quotas for private banks. Consequently, Window Guidance allowed the BoJ to directly control the quantity of bank credit in the economy and even its composition by sectors. Although the monetary policies combined with the industrial ones issued by MITI played a key role in stimulating the post-war economy, they contributed to the formation of an enormous asset price bubble too. Then, when the BoJ tried to tighten lending standards through multiple rate increases in the 90’s, the bubble finally popped.
The succeeding decades revived fears of the so called “Secular Stagnation” because the economy was able to achieve satisfactory growth rates only if supported by an extraordinary monetary and fiscal stimulus (proved when normalization attempts resulted in deceleration in 2000 and 2006), while experiencing low inflation or even deflation.
Monetary policy evolvement
The traditional monetary stimulus method is to bring policy interest rate below the natural interest rate. So far, we have seen several reasons why the golden rule is hard to apply in Japan: companies’ high reliance on bank credit undermined interest rate effectiveness. In fact, post-crisis weakness in the banking system due to high rates of NPLs left companies with nowhere to go and forced them to minimize debts, resulting in a “Balance sheet recession” (as described by Richard Koo) that lowered investment opportunities contributing to a strong decline in the natural rate of interest. Demographically, the natural rate of interest, which should be neutral to economic growth, was dragged down further by factors like slower labor force and TFP (Total Factor Productivity) growth and an aging population which tends to save more. The chase of policy interest rate after declining growth rate (as well as natural interest rate) lasted in the 90s and ended up in 1999 at zero, a bound BoJ has tried to break through with various untraditional policy tools.
- From front-end to back-end
In order to influence the long-term rates, BoJ adopted forward guidance based on the 1999 zero-rate policy by committing the future path of short-term rates. Through risk asset purchasing such as 2001 Quantitative Easing program, risk premium could be suppressed by the central bank, reducing the term premium and thus the long-term rate. Meanwhile inflation still remained around 0 even till QE1 lifted and rate hiked in 2006.
After Lehman crisis, another round of asset pricing was launched in 2010 and barely stimulated the economy albeit the gradual scale-up in the annual purchase amount.
- From rate to monetary base
The QQE framework launched in 2013 enabled the purchasing of government bonds on a larger scale as well as for ETFs, which helped reduce risk premium, push up stock market and diminish corporate bond yields. Nevertheless, CPI-denoted inflation did not manage to show consistently a positive value.
- Confidence restoration
According to studies, deflation tends to haunt as its presence gets entrenched: under expectation of deflation for a prolonged period, promises to keep policy rates low until a distant point in the future when inflation will eventually increase are largely ineffective to stimulate present output and inflation (Katagiri 2016). BoJ has been reiterating its commitment about the 2% target to the public since 2013.
- Removal of zero bound
Following ECB’s unprecedented rate cut in 2014, BoJ in 2016 decided to further reduce the commercial bank rate and the 10-year yield finally dipped below zero, along with a downward shift of the yield curve.
- Yield Curve Control
Bank of Japan in 2016 targeted a 0% yield on 10-year bonds, a method firstly employed by the Fed in the 1940’s when it pegged the yield of long-term debts. Generally central banks implement quantitative easing buying a specific quantity of a financial assets, letting markets determine prices; instead, with yield targeting, the central bank commits to stabilize the price of a certain financial asset buying or selling around that price undefined quantities.
There are risks associated to this monetary tool: the central bank may face difficulties if its peg is not credible because it would have to buy a huge quantity of that financial asset. However, with this policy the central bank can avoid a flat yield curve and keep a gap between short-and long-term interest rates; this is very important in order to preserve profit margins for insurance companies and banks, which in turn encourages lending, and for long term investors like pension fund.
Situation in Eurozone
Similarities can be spotted between post-90s Japan and Eurozone’s recovery from the crisis in terms of inflation, growth and demographic trends.
ECB has certainly achieved more on the “close to 2%” inflation target. Moreover, the ECB is burdened with a much lower debt-to-GDP ratio, a less-so-enormous balance sheet asset amount, but is limited by higher unemployment rate and macroeconomic imbalance among the member states.
Taking into account the lessons we learnt from BoJ and phenomenon in Eurozone, we discuss here several monetary tools aside from asset purchasing, forward guidance and negative rate which are already in place and not to be ended in a short term.
Yield curve control has been discussed as a possible resort for the ECB, with the main merit of reducing spread between the peripheral countries’ nominal GDP growth and borrowing costs by capping 10-year Euro area debt. Meanwhile, targeted yield might induce excess government borrowing, a concern mainly for fiscally austere members—often high earners.
As a resolution for debt crisis once backed by Soros, the issuance of Eurobond was raised again and not completely denied “as a rational safety asset” in the March rate meeting. However, the difficulty of political decision, especially for Germany, is not decreased today.
BOJ’s equity purchasing has buoyed stock market in Japan and made itself a prominent shareholder. Accordingly, holding major ETFs will bring about higher risks compared to the current ECB portfolio. Different from the drawback of bond yield-targeting, ETF purchasing will probably benefit only the countries with strong presence as constituents.
The Global Financial Crises has also led central banks to introduce or consider monetary tools anchored at different variables to achieve their inflation target.
Price level targeting is a new monetary policy framework to avoid hitting the ELB (effective lower bound) and liquidity trap situations. Price level targeting seeks to maintain the price level around a stable long-term path constructed considering that an x% CPI number is constantly achieved over time; for this reason, if a country undershoots its inflation target for one or more years, markets should expect higher future inflation and this expectation should limit present downward pressure on the inflation rate. Instead flexible inflation targeting ignores past deviations from the target and aims to reach the target over time.
However, price level targeting has been employed only by Sweden in 1930 and is criticized because it relies on strong assumptions. First, it assumes that agents have rational expectations about the economy and are forward looking, and then that the strategy is credible. If these conditions do not hold this framework may dis-anchor inflation expectations and have a worse outcome than flexible inflation targeting.
Finally, the framework nominal GDP, unimplemented by central banks so far, either targets the growth rate of GDP without taking into account past deviations, or the level of GDP constructed adding an inflation target and an estimate of potential GDP growth. Nominal GDP targeting implies that periods of low growth would have higher inflation, and consequently a lower chance of hitting the ELB, while periods of high growth would have lower inflation.
The long-term dynamics of the Eurozone that we analyzed seem to point at a “Japanification” of the Old Continent; if this hypothesis is correct, the Euro area may face lower than expected interest rates in the future. Moreover, the increasing political uncertainty for the incoming European elections and the polarization of the political parties throughout the entire continent may further weaken the Euro. In this scenario, a carry trade borrowing in euros may be very profitable. A carry trade is a strategy where an investor borrows in a low-yielding currency to lend in a high-yielding currency, consequently profits depend on the differential between the two rates of interests, the leverage that is employed and the movements in the exchange rate. An investor may borrow in euros to invest in US or in Emerging Markets which generally offer a higher yield. However, investing in the US may be safer in order to partially hedge the risk of a normalization in the interest rate policy: in this situation Emerging Markets currencies would be the ones weakening the most with respect to the Euro and this may erode the potential gains from the higher interest rate differential.
We also believe that yield curve control might be the most plausible reference in the BoJ non-traditional monetary policies toolbox to realize growth and inflation target before monetary policy normalisation, which is not expected to start in the short run as confirmed by the decisions of prolonged rate level sustaining and reinvestment policy. Nevertheless, within this year we are also expecting the step-down of 3 executive board members including Draghi and nearly half of the governors in rate-setting body. The next president will inevitably shoulder the responsibility to bring up normalization to agenda and among them there are several German hawkish candidates and Benoît Cœuré, who claimed interest rate to be “main instrument of monetary policy” recently.