Financial Times February 22nd 2012
Has the last samurai of the hard money clan finally hung up his sword? It certainly looks that way. The Bank of Japan’s recent decision to adopt an inflation target and double its bond purchase program completes the global flight to soft money. The implications are likely to be profound.
The biggest surprise was the timing. In late January Bank of Japan Governor Masaaki Shirakawa was in London repeating the standard BoJ mantra – Japanese deflation was structural and nothing could be done about it. A few weeks later he was joining the ranks of the monetary activists.
Why the sudden volte face? Political reality, is the likely answer. The Bank of Japan’s isolation had become increasingly untenable.
In the aftermath of the Lehman shock in 2008, the US Federal Reserve and the Bank of England embarked on aggressive programs of quantitative easing, which involved buying massive amounts of government bonds. Emerging economies with currencies linked to the US dollar joined the party by effectively “importing” the super-easy US monetary policy.
In 2011 the European and Swiss central banks, traditionally bastions of hard money orthodoxy, defected to the reflationist camp. In both cases the decisions were rooted in political pragmatism, rather than ideological conviction. The Swiss problem was the suffocating effect on economic activity of the soaraway swiss franc. The ECB’s pressing need was to backstop the banking system’s exposure to the dodgy debts of the eurozone periphery.
These were symptoms of a larger malaise – the stresses and strains endemic to a world of high debt burdens and low or no growth. In the developed world the balance of social and political risk is driving policy one way – to reflation, by any means possible. In the emerging world the policy-makers – often in politically fragile positions themselves – have chosen to go with the flow in order to protect export sector jobs.
As the dominoes fell, the Bank of Japan’s rigidity became more anomalous. Earlier this month Mr. Shirakawa was given an unusually rough ride when he appeared before the Diet. There were strident protests from corporate Japan at the surge in the yen – the inevitable result of sticking to hard currency principles in a soft currency world. Such great names of Japanese industry as Sony, Sharp and Panasonic were haemorrhaging red ink while Samsung chalked up record profits. The doubling in the yen-won cross rate since 2007 was not the only factor in the loss of competitiveness, but it certainly didn’t help.
The BoJ maintains that it arrived at its new policies with no outside coercion. Even so Mr. Shirakawa has stated that the 1% inflation target may be subject to upward revision. On most objective measures, there is plenty of ground to make up. Japan ‘s GDP deflator has been declining at 1-2% per year for the last twelve years, but the BoJ’s balance sheet is smaller now than in 2007. Over the same period the balance sheets of the US, UK and Swiss central banks have trebled and the ECB’s has doubled.
Put in this context, the BoJ’s ten trillion yen of new asset purchases are little more than “the tears of a sparrow.” To make an impact, it will have to do much more. In the end it will, like it or not. In political terms, the bank has put itself in play.
The first effect will be on financial markets. If a central bank accumulates assets that would have otherwise been bought by private investors, those investors have to find something else to do with their money. The experience of the past few years is that artificial reduction of the supply of risk-free assets ignites demand for risky assets. Saying sayonara to hard money could mark the start of the Tokyo market’s participation in the global risk-on trade.
The effect on the real economy is trickier to assess. Even the Bank of England, which has hoovered up 25% of the gilts market, has not succeeding in raising inflationary expectations beyond pre-crisis levels. In a deleveraging world, the effect of higher stock prices has limited impact. Likewise, a single country can become more competitive by depreciating its currency, but that cannot work for the everyone.
One way – for Japan and the world as a whole – to raise inflationary expectations would to be to generate such a powerful rise in stock prices that investors start to diversify into hard assets such as real estate and commodities. A rise in the price of “things” is the essence of inflation.
Such a fundamental reset of financial conditions could not be accomplished overnight. Just as it was twenty years after the inflationary peaks of the mid-seventies before inflation was definitively vanquished, so it may take several cycles before the threat of debt and deflation can be laid to rest.
Interestingly, it was the countries with the worst inflation problems – such as the UK and the US – that benefited most from the global struggle to tame inflation. Japan, which already had sub-3% inflation in the early 1980s, ended up sinking into deflation.
If the world follows the same template this time, it would be the countries with serious deflation problems that benefit the most from global reflation, while some of the high-growth countries could end up with double digit inflation.
The notion that the stagnant, debt-raddled economies of Japan and core Europe could provide better investment opportunities than the stars of the emerging world seems preposterous. But is it any more preposterous than the notion in 1974 that the best performing stock market of the coming quarter of a century would belong to the inflation-plagued, strike-bound “sick man of Europe,” the UK?
It may seem a long way from here to there, but if central banks are to target higher inflation they have little choice but to keep the pedal to the metal.
With the tyre treads gone and the sat-nav broken, the ride is unlikely to be smooth.