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The Bank of Japan breaks more taboos

Such steps only expose how ineffectual central banks have become.


Simon Doyle

Simon Doyle

Head of Fixed Income & Multi-Asset

The Bank of Japan, in its quest to revive Japan’s deflation-prone economy, pioneered zero cash rates in 1999, invented quantitative easing in 2001 and resorted to negative deposit interest rates earlier this year.

Its latest unorthodox move, the central bank has announced it will target the 10-year government bond yields for the first time. In September, the bank said it would alter the mix of its asset buying under its latest quantitative-easing program to keep 10-year yields at zero, rather than below nought where they have sat most of this year. At the same time, Governor Haruhiko Kuroda said the Bank of Japan would expand the monetary base (supply) until inflation rose beyond 2%.

The bank is attempting to alter consumer expectations about inflation and take more control of the yield curve because the looser monetary policy introduced after Prime Minister Shinzō Abe’s election in 2012 is failing to resuscitate Japan’s economy or generate enough inflation.

The Bank of Japan’s latest experiment served to highlight a growing concern about central banking these days; that the unprecedented steps taken by the world’s major central banks in recent years are failing to return economies to lasting health or stave off deflation. Given these failures, the call is for more fiscal stimulus. But fiscal policy has its limits too.

Central banks, to be sure, were never meant to be the only massagers of economic growth. Even with Abenomics, for example, monetary policy was just one of three prongs; fiscal policy and micro-economic reforms being the others. Sluggish global growth would keep interest rates at low levels anyway; it’s not all the doing of central banks. Monetary policies could be looser still – but only at the margin and to questionable effect given the way it garbles asset pricing. It’s clear that central bankers have wrung as much as they can from traditional tools and their unprecedented steps. Something new must be tried. A danger with a shift from monetary to fiscal policy, though, is that the adjustment could even trigger an unwinding of the distortions central banks have created in asset markets.


The concerns about the radical monetary-policy steps of recent times are based on their potential side-effects as much as their ineffectiveness. Asset buying under quantitative easing and prevailing low interest rates have driven up asset prices to levels that signal that risk is being mispriced. Sovereign bonds are at the heart of this rupture between the pricing of risk and the inherent riskiness of asset classes. As bond yields set the discount rate applied to other assets, prices have risen across the investment spectrum. If yields stay low and cash flows continue as assumed, then all is well. But watch out if either of these assumptions is tested.

Negative interest rates, which were first introduced by the Denmark in 2012, are as problematic. They threaten the traditional bank business model, which impedes lending. They make it hard for defined-benefit pension funds and insurance companies with guaranteed-return products to match liabilities with assets or generate enough return. As well as making bonds vulnerable, negative interest rates have a counterproductive effect on consumer behaviour. Rather than spend, households are saving more. People are reducing purchases to compensate for lost income and seem worried that something must be amiss if such crazy rates abound.

The pressure on banks and the unexpected consumer reaction are why the Bank of Japan has taken the perverse steps of promising a loose monetary policy while trying to push rates higher – even if that’s from negative to zero. The success of the move will largely come down to whether the population’s inflation expectations rise as the central bank intends. Japanese consumer prices excluding food slid 0.5% in the 12 months to August, so convincing households that inflation will climb won’t be easy.

The quandary

The Bank of Japan’s latest move recalls the Federal Reserve’s so-called “operation twist” of 2011 when it bought long-term bonds and sold short-term Treasuries as part of efforts to lower long-term US yields. This attempt to manipulate the yield curve, along with the Fed’s three asset-buying programs from 2008 to 2013 and zero interest rates from 2008 to 2015 had more success in reviving the US economy than enjoyed by the Bank of Japan or the European Central Bank, which has overseen a zero cash rate more or less since 2014, negative deposit rates since 2014 and quantitative easing since 2015.

But the Fed has not been successful enough. The Fed wants to raise the cash rate from the 0.25% it has sat since December but it can’t get ticks on its three criteria: strong US domestic growth, an expanding world economy and limited backlash on financial markets puffed by its asset buying. So for the sixth straight policy meeting there was no rate increase in September. The danger is that the US economic upturn is maturing – the jobless rate was at a post-crisis low of 4.7% in May this year – and the Fed won’t be able to help if activity slows. Hence calls by Fed officials including Janet Yellen for more fiscal stimulus. Such comments are matched by bodies such as the IMF and OECD. The push is on for a synchronised (“collective” in OECD speak) boost to fiscal stimulus across advanced economies.

Such prescriptions make sense when today’s interest rates make government borrowing so cheap. Events are forcing fiscal policy looser anyway. In Europe, the populist reaction against austerity is prompting eurozone governments (Spain and Portugal to name two) to delay meeting legal fiscal constraints. The UK government is easing fiscal policy to combat the uncertainty created by the vote to leave the EU. At the same time, Europe’s immigration crisis and security concerns are encouraging more public spending. In the US, the presidential candidates are announcing promises without solid plans to pay for them, while emphasising the need to spend more on ageing infrastructure. In Japan, the government is delaying another increase in the sales tax.

The high debt levels of most advanced governments, however, limit how much fiscal stimulus can be applied. In the eurozone, general government gross debt was 91% of GDP in 2015, according to eurostat. Gross debt in Japan reached 248% of output and for the US it was 105%, according to the IMF. There is no guarantee that fiscal stimulus will boost nominal GDP enough to reduce these debt ratios. Even more concerning for investors, looser fiscal policy might prompt central banks to ease back on the measures that have inflated bond prices, triggering a sell-down. It’s not an easy time to be a policymaker.

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