One-two punch

The Bank of Japan (BoJ) concludes its latest policy meeting tomorrow and the expectation is that it will announce new monetary measures to help lift the economy from lapsing into recession, as well as curing a long-lasting deflationary mindset. If the BoJ does actually announce new measures, then this will look like a ‘one-two punch’ to complement the latest fiscal measures, which amount to new spending of JPY 6tn. Of course, the BoJ’s monetary measures, which have taken the central bank’s balance sheet to about 90% of GDP and resulted in the BoJ owning nearly 40% of outstanding Japanese government bonds, have not really delivered the results that the BoJ had been looking for. Will doing more of the same produce different outcomes or is the BoJ’s programme simply evidence that ‘unconventional’ monetary policies have now reached the limit their effectiveness?

The Neo-Fisherite school of thought, named after the US economist Irving Fisher, believes that central banks can increase inflation by increasing their nominal interest rate targets, which is radical given that conventional monetary thought believes that reductions in interest rates result in higher inflation. The ‘Fisher Effect’ sees a positive relationship between the nominal interest rate and inflation, so if you want inflation to go up, then you should raise interest rates. Likewise, a low interest rate must lead to low levels of inflation or in fact ultra-easy monetary policies are actually deflationary. If the Neo-Fisherites are right, then it turns our thinking of how monetary policy works on its head and might explain why investors are concerned that all the variants of unconventional monetary policy are proving ineffective. Investors cannot make money when money yields nothing, especially if investors start to believe that ‘lower for longer’ is starting to mean ‘lower for ever’.

There are many commentators who argue that zero/negative interest rates are destroying financial capitalism and creating dislocation in saving and investment decisions. However, it is unlikely that the major central banks will ever embrace the Neo-Fisherian school of thought and unconventional monetary policies (ZIRP, NIRP, QE, HM) have now become conventional (readers interested in this should read Neo-Fisherism: A Radical Idea or the Most Obvious Solution to the Low-Inflation Problem, by Stephen Williamson at the St Louis Fed)

For a country like Japan, that is experiencing adverse demographic factors and has a substantial debt overhang in the public sector, potential GDP inevitably declines. Balance sheet recessions require substantial deleveraging before any policy stimulus encourages households and corporates to start spending again. Negative interest rates, a tax on banks, only ends up being counter-productive as lost income from net interest margins are passed on to borrowers and banks turn into ‘zombie’ banks. In this regard, there is a real risk that the BoJ’s efforts will end up failing and that the ‘fiscal stimulus’ makes little difference to the longer-term trajectory of the Japanese economy.

Nevertheless, as we have discussed in our research notes this week, there is greater focus from policy-makers, as highlighted in last weekend’s G20 communique on the use of fiscal policy as tool of demand management. It is certainly true that in the major economies, public sector capital spending has fallen to low levels as a percentage of GDP and that there is a strong case for increases in infrastructure spending.

For investors anticipating that equity markets will respond to a new ‘reflationary’, rather than a deflationary, theme, that has on occasion unsettled the markets, this policy shift could be a positive development. The IMF, in its latest assessment of global imbalances, remarks that “surplus countries with fiscal space have a greater role to play in supporting global demand while reducing external imbalances.” This advice seems particularly directed at Germany, where the current account surplus has risen to 8% of GDP. Is Wolfgang Schauble, the German Finance Minister, listening?

The IMF warns that “while the present configuration of imbalances is far from the conjucture that led to the 1985 Plaza Accord, a further widening of imbalances could also give rise to protectionist policies, with pervasive effects on global growth.” It is interesting to note that Donald Trump is threatening to exit the 163-country World Trade Organization (WTO) which he labelled ‘a disaster’. The US currently has free trade agreements (FTAs) with only 20 countries, which means US firms enjoy preferential access to these countries’ markets at mostly zero or low import tariff rates. A pullout from the WTO would increase the export disadvantage for the US

Certainly, in the medium term, fiscal policy (which has been neutral in the US and restrictive in the Eurozone) is likely to move towards a more expansionary stance, though in the Eurozone this might have to wait until the French and German elections in 2017 are out of the way. Nevertheless, there already seems to be a push-back against fiscal austerity, with the EU this week deciding not to impose penalties on Spain and Portugal for missing budget targets. Of course, what Brexit has done is to concentrate the minds of EU policymakers on avoiding antagonising voters into supporting increasingly popular anti-euro political parties.

In the meantime, the Fed decided to keep policy on hold, as expected, at the conclusion of its latest policy meeting yesterday. The FOMC statement was modestly upbeat about the prospects for the US economy and the statement noted a diminishing of risks to the outlook. Certainly, the economic and financial impact of the Brexit vote seems to have been grossly exaggerated by the vast majority of economists, who made the mistake of conflating their pro-EU sympathies with ‘factual’ economic analysis. An admission of error is unlikely though. The depreciation in the sterling exchange rate has already seen a number of major companies commit capital spending to the UK and the notion that London as a financial centre will be usurped by Paris or Frankfurt is wishful thinking (for example, see The Next European Financial Capital: London, by Simeon Djankov at the PIIE).

As far as US monetary policy is concerned, the FOMC is obviously keeping its options open and a rate hike at the September or December FOMC meetings is still on the cards. We have previously noted that the impact of upcoming US money market reforms, which have triggered outflows from prime money market funds, has acted to push up LIBOR rates and other short-term borrowing costs. In a sense, this acts as an implicit form of monetary tightening and it might well be that the FOMC decides to move in September just to keep up with movements at the short end of the money market and avoid criticism of actually falling behind the curve.

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