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The Bank of Japan’s announcement of Yield Curve Control might look like an arcane piece of monetary policy from an economy that has struggled to escape from deflation. But for central bank watchers in Europe – all investors should be central bank watchers these days – it may provide a roadmap to the future.
First, the detail. Rather than go further into negative interest rate territory to stimulate its economy the Japanese central bank held firm to its -0.1pc deposit rate at a meeting last week. Instead, the BoJ focused on the yield on Japanese government debt, 10-year bonds to be precise, promising to buy as many as is necessary to keep yields at current levels of around 0pc.
The idea is to guard against “yield curve flattening”, which is what happens when there is little or no compensation for investors who buy longer-dated bonds, leading to a flatline on traders’ screens rather than the typical upward slope that denotes a healthy economy and also provides reasonable compensation for buying longer-dated instruments.
This flattening is an unwanted side effect of the central bank bond purchasing seen across major economies in recent years. Designed, like low or negative rates, to boost lending and corporate activity by reducing borrowing costs, when such purchasing flattens the yield curve, it has the opposite effect: banks tend to reduce lending as their compensation for doing so is reduced. This would not be an issue if banks were able to pass on the cost of negative short rates to consumers, but they are reluctant to do so for fear that depositors would take their money out of the system.
By instituting Yield Curve Control, the BoJ is hoping to ensure that banks continue to be rewarded for lending, as far as is possible in an economy where borrowing costs are being kept at historically low levels in order to meet the inflation target of 2pc.
The policy is a telling admission of the limited ability of negative short-term rates. By refusing to cut further the BoJ is implicitly turning from them as a means of promoting economic activity. This should be a concern in Frankfurt, as the Eurozone deposit rate is set much lower than Japan’s at -0.4pc.
“Abenomics”, of course, have been in place for longer than the eurozone has been exploring negative rates and quantitative easing. Government debt levels and demographics remain more favourable in Europe than Japan. Nevertheless, similar issues exist and unless European growth can improve on a sustainable basis the moves by the BoJ may be something the ECB will need to consider in the next few years.
Negative rates could yet provide the boost the EU needs to stave off recession, but if they do not, what is left in the toolbox? Through its QE programme, which is ploughing through ever-riskier assets – such as corporate bonds – to boost lending to the real economy, the ECB is already pursuing parallel measures to its policy on negative rates, without an obvious effect on realised or expected inflation.
In a traditional economy, the obvious next move would be for the political leadership to recognise that monetary policy has its limitations and accept the need for fiscal easing, for example by boosting infrastructure spending. Germany, the EU’s leading economy, certainly has the cash to do this, but it has little incentive to do so at home – where public infrastructure is already impressive – and there is no public appetite for it to do so elsewhere in the EU: not for the first time, the EU’s unique structure of a single economic area provides an obstacle for policymakers.
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Without that fiscal boost from the politicians, the ECB has little option but to continue on its current track and hope that the measures it has already instituted eventually have the desired stimulatory effect. The problem is that such measures cannot be continued indefinitely.
In addition to Yield Curve Control, the BoJ announced on Wednesday that it was committed not just to hitting its 2pc inflation target, but to exceeding it. Leaving aside the question mark this raises over the central bank’s credibility, that promise will remind those with a long-term view of the perils of extreme policies such as those being explored by the ECB and BoJ.
The BoJ estimated last week that its monetary base – the currency in public circulation or held in reserve – is likely to increase from 80pc of GDP to 100pc over the next year or so. A central bank’s defining attribute is the ability to print money, but it cannot do so forever. Once investors at home and abroad decide their money is better off elsewhere, the inflationary effect of the consequent currency depreciation can swiftly become uncontainable. We are very, very far from this, both in Europe and Japan, but it is worth remembering that Germany’s habitual caution is rooted in the bitter experience of 1920s hyperinflation.
The UK is in a happier position than the eurozone. While we are a long way from clarity on the long-term effect of the Brexit vote, the limited economic information available from the post-referendum period is far from apocalyptic, and the new Government is much less focused on fiscal austerity than its predecessor.
The challenge for the UK is that it is a small, open economy running a large current account deficit, requiring ongoing finance from abroad. Should the economy falter, it has flexibility on the currency side that the individual eurozone countries lack: it can pursue policies designed to devalue the currency thereby boosting its attractions for foreign investors.
This is a crucial ability, but not an entirely dependable one: if everyone is easing financial conditions by devaluing – so called currency wars – the trade channel offered by weaker sterling might not be there when needed. And if the deficit grows unsustainably, that cherished safe-haven status might be difficult to preserve.
Extraordinary monetary policy has had some extraordinary results – not least in the eurozone and in Japan – but in a worst-case scenario it also carries extraordinary risks. We have seen some of the most adaptable minds in economic history at work in central banks over recent years, engaged in unprecedented policy innovation. They have made history, but their biggest achievement would be the return of simple, sustainable consumer spending and commercial investment.
Andrew Wilson is EMEA chief executive of Goldman Sachs Asset Management
Europe should look to Japan for warning signs on negative rates