Japan: 20 years of easy money – success or failure?

The Bank of Japan’s policy rate has been below 0.5% since December 1995. In addition to holding the policy rate at about zero, the central bank has vastly increased the amount of “base money”.

Since December 1995 the average rate of inflation has been 0.1% per year. Stripping out the direct effect of sales tax alterations and excluding food and energy prices, the consumer price level has been stable. If the Bank of Japan had strived for price stability, its policies would have been a success story.

But the Bank of Japan is striving for inflation, and since 2012 the target has been 2% annual inflation. Judged by its ability to generate inflation, the Bank of Japan’s policies have been a failure.

Recent inflation – not different from post-95 average
The sales tax was hiked in March 2014. Since April 2014 consumer prices have risen by an annualized rate of 0.1%. Excluding fresh food and energy the annual rate of inflation has been 0.2%. This index ticked up a bit in the middle of last year. But the core consumer price level was the same in January as in August last year. Currently the rate of growth of the core consumer price inflation is zero. (I have used the consumer price index for Ku area Tokyo, which tracks the national index closely, but is updated faster than the national index.)

The Bank of Japan’s latest move
On January 29 the Bank of Japan cut the effective policy rate – the marginal interest rate on central bank deposits – to minus 0.1%. This takes effect on February 16. The central bank said that this deposit rate might be cut further in the months ahead. Markets reacted by cutting long-term interest rates.

As of February 8, the 10-year interest rate was 0.03% down from 0.22% on January 28. It is unclear how far the Bank of Japan can and will cut the marginal interest rate on central bank deposits. (The Swiss National Bank’s marginal depositrate, which is the lowest in the world, is minus 0.75%.).

Expected inflation fell after the policy rate cut
Expected inflation fell after the interest rate cut was announced. Currently the inflation swap
market expects inflation to average 0.49% per year over the next 10 years. That is down from 0.59% before the monetary policy announcement on January 29. Real interest rates, i.e. the yield on CPI-linked bonds, was 0.37% on January 28 and currently trades at 0.35%.

The decrease in the nominal 10-year government interest rate is almost entirely due to lower
expected inflation. The rationale behind the interest rate cut was to increase expected inflation, causing real interest rates to drop. Such a drop is supposed to increase consumption and investment, generating higher GDP growth, less unemployment and higher inflation.

The yen is higher than before the interest rate cut
The Bank of Japan might have thought that an interest rate cut would depreciate the JPY, and that a depreciation would boost net exports, increase GDP growth, lower unemployment, and raise inflation. Measured by a trade-weighted index, the JPY depreciated after the January 29 announcement. From January 28 to February 1 the JPY fell 2%. Since then the yen has appreciated. At market close on February 5, the JPY index was 1% higher than on January 28. The FX market reaction has not been in line with what the Bank of Japan likely expected. A stronger JPY makes sense if markets expect less inflation in Japan.

What’s next for the Bank of Japan?
I don’t think that the market reaction since its January 28 decision has influenced its thinking yet. And it is unlikely that the Bank of Japan will alter its view on how monetary policy affects inflation in the near future. So the policy rate might be cut further. But what if, as I think is most likely, the effect of such policies are further cuts in expected inflation and a stronger JPY? At some point, maybe after the Bank of Japan has found the effective lower bond – where banks begin to swap central bank deposits for notes – the Bank of Japan will be forced to alter its modus operandi. That is, the central bank that initiated zero interest rate policy and quantitative easing, and fought a futile 20 year campaign to inflate the economy might at some point change course and overhaul its policies.

Torgeir Høien, portfolio manager Skagen Tellus

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