Placing our trust in unconventional monetary policy

This was because the market read the Fed announcement on interest rates as dovish on keeping rates low. It concluded that US “economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run”. 

Two days later, Bank of Japan (BoJ) governor Haruhiko Kuroda announced the opposite view, that in pursuit of its QQE (quantitative and qualitative monetary easing), the BoJ “will do whatever it can to overcome the deflation that has long undermined the Japanese economy”. The QQE seeks to achieve an inflation target of 2 per cent per annum within two years. The new QQE measures would increase the monetary base from an annual pace of ¥60-70 trillion to an annual pace of about ¥80 trillion. Furthermore, the amount of bonds held by the BoJ would increase from an annual pace of about ¥50 trillion to an annual pace of ¥80 trillion. Also, the BoJ would triple the annual increases in purchases of exchange traded funds (ETFs) and Japan real estate investment trusts (J-REITs) from an annual pace of ¥30 billion to an annual pace of ¥90 billion.” The Nikkei stock index went up, despite the gloomy world outlook.

In plain language, the BoJ is not only willing to increase its bond and stock index purchases, but also do so by increasing its monetary base, namely, partly printing money. Central banks have always been careful to distinguish between quantitative easing by buying bonds from the market, which tends to increase liquidity of banks, from the actual printing of money through its monetary base. Technically, the first swaps bonds, held previously by banks and asset managers, into deposits with the central bank, while the second simply creates the money by buying the bond outright.

QE was introduced in 2008 when central banks lowered interest rates to near zero – so you can’t adjust the price further downward. The European Central Bank (ECB) recently even breached this zero level with negative interest rates, charging banks for putting money with it. However, the ECB has been the most cautious in using QE, having doubled its balance sheet between 2011 and 2012, when ECB president Mario Draghi announced “whatever it takes” to stop the European debt crisis. But since early 2012, the ECB has withdrawn much of its asset purchases, because surplus economies like Germany prefer more cautious monetary policy out of a historical fear of inflation. 

We should look at QE in perspective. Since 2008, the Fed has increased its balance sheet fivefold, the Bank of England just over fourfold, the Bank of Japan two and a half times and the ECB about 40 per cent higher than its 2008 level. These are historically unprecedented rises.

The bottom line is that the US and UK economy have recovered somewhat, but remain below their long-term potential. The Japanese economy is still flattish, despite Abenomics and QQE, and the European economy is not only sputtering but threatens to enter deflation. This is despite the fact that world oil prices are declining, which is positive for stimulating consumption. 

The desire in the advanced countries for higher inflation is convoluted. On the one hand, they think that with higher liquidity and inflation, consumption would actually increase. On the other, the overhang of their fiscal debt, which is the highest ever since World War II, can only be reduced through higher inflation. Instead, QE has increased asset prices, with London real estate prices rising to record levels. 

Nobel-winning economist Paul Krugman did something remarkable this month when he remarked in his New York Times column that Western economists should apologise for criticising Japan for being always “too slow and too late” in economic policy. Japan was the first to fall into the “debt deflation” trap, and tried everything from fiscal pumping and loose monetary policy to deal with it, without much success. Krugman thinks that the West not only did not learn from Japan, but performed worse, pointing out the follies of Europe. 

The basic problem with clever economics is that reality is never congruent with elegant theory. 

Central bankers stepped in with unconventional monetary policy because the politicians couldn’t get their act together to do the unpleasant task of making structural reforms. Japanese QQE is necessarily “shock and awe” because the Third Arrow of structural reforms in Abenomics has not been delivered. Japan is still going through its balance sheet recession, and even though QQE is not directed at the exchange rate, a depreciation of the yen rate is critical to the re-writing of the national balance sheet. 

At the end of 2012, Japan had ¥296 trillion of net foreign assets or about 60 per cent of GDP. The BoJ estimated that a 1 per cent depreciation of the yen would increase net foreign assets by 1.2 per cent or ¥3.7 trillion. Since 2012, the yen has moved from 86 to 114 per US dollar or depreciated nearly 25 per cent. By the same token, the net foreign asset value has increased by 30 per cent or equivalent to 18 per cent of GDP. In short, in yen terms, there is a large positive wealth effect for the Japanese economy from devaluation, on top of the gain in export competitiveness. 

If this still does not work, something is seriously wrong with either economic theory or the Japanese economy. 

Speaking to new graduates at Kuala Lumpur’s University of Abdul Razak this month, Chancellor Tun Ahmad Sarji quoted American polymath Oliver Wendell Holmes: “Put not your trust in money, but put your money in trust”. 

Spot on. 

In this age of QE, if you can’t trust money and central banks, whom can you trust? As its says on US coins, “In God We Trust”. 

 

Andrew Sheng is writing a book on global finance from Asian perspectives.