27 Jan 2016
What once was a subject for monetary boffins – how do you stimulate an economy when it already costs nothing to borrow? – is now a matter of operational importance for the world's central banks.
" Offered a choice of putting money in a bank at less than zero rates, holders of hard currency would be expected to just hold the cash."
Andrew Cornell, BlueNotes managing editor
Essentially it is the problem John Maynard Keynes identified with his graphic analogy of trying to push string: if investors don't want to invest they don't need funds. And if they don't need funds it doesn't matter how cheap those funds are.
But the Japanese situation also focusses attention on the mechanics of such a policy and this is something else altogether: what can you do when the price of central bank money has reached what is known as the “zero lower bound” (ZLB)? For rates to be negative, investors must pay to deposit money rather than receive a return, however small.
Japan's economic situation is peculiar in that it has never recovered from the collapse of its property and financial markets bubble of the late 90s and has long struggled to stabilise ballooning government debt level and combat deflation.
(Although some economists argue Japan's economy is actually functioning well per capita, the problem is the population is ageing and shrinking in numbers.)
One issue is that while zero rates can work on electronic money because this is typically held in bank accounts ultimately influenced by the electronic money banks have on deposit at central banks (which can be charged as well as credited), they don't work with hard currency.
Offered a choice of putting money in a bank at less than zero rates, holders of hard currency would be expected to just hold the cash. After all, it is the threat of inflation reducing the face value of cash which drives investment. But no return, no inflation, no reason to put the money in a bank and hence no transmission of negative returns.
Another challenge is central banks have come to increasingly rely on “jawboning” – that is markets will react to what banks say they will do before they do it. Sometimes to the extent it doesn't even need to be done (or not as much).
This tool has become increasingly important over the last decade as the era of inscrutable, unaccountable and generally silent central bankers has passed into history.
The problem is this policy tool is something of a confidence trick: once the market understands the trick, it no longer works.
This appears to already be the case with one Washington Post analyst's description of the Bank of Japan's latest move as a “Jedi mind trick” receiving wide engagement – not least because, as TTT Consulting's Sean Keane noted in his Credit Suisse analysis, “The BOJ has titled its amended policy setting 'The Introduction of Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest Rate', a title certain to send the YouTube generation of young traders straight to sleep”.
“Getting the term 'Jedi Mind Trick' into the headline would likely have weakened the policy message but it would certainly have upped the readership of the BOJ's Q&A release on Friday, and possibly generated a closer reading of the policy release.”
The BOJ hasn't actually moved to a negative rate policy, or at least, not a uniform one. Deposits currently with the bank won't be affected at all and new deposits only at a tiered rate which Keane says is “far less immediately impactful”.
“The three tiers of deposits will be remunerated at different rates of interest and a bank will only be penalised with negative rates if it 'increases its cash holdings significantly',” he says.
“The BOJ move is thus more forward looking in its impact, rather than having an immediate effect on current balances.”
In essence, more jawboning.
The most comprehensive analysis of the challenges of a ZLB was Bank of England chief economist Andrew Haldane's in a paper last September, How low can you go?
“If global real interest rates are persistently lower, central banks may then need to think imaginatively about how to deal on a more durable basis with the technological constraint imposed by the zero lower bound on interest rates,” he said.
“That may require a rethink, a fairly fundamental one, of a number of current central bank practices….Without the ability to (set negative rates) on currency, there is an incentive to switch to currency whenever interest rates on reserves turn negative.”
How this dilemma plays out in Japan is interesting because it is harder for corporates to hold large amounts of hard currency than individuals and it is the corporates, not the household sector, hoarding cash in Japan. So maybe the Jedi trick might work.
Haldane noted in the 90s typical global, long term interest rates were around 6 per cent – 4 per cent rates and 2 per cent inflation – leaving plenty of room to move during a cycle. While inflation is still around 2 per cent globally, rates are near enough to zero, leaving much less policy room.
Haldane broke down the 4.5 percentage point fall in rates since the 90s into lower trend growth (100 basis points); worsening demographic trends (90 basis points); low investment rates due to the falling price of capital goods (50 basis points); rising inequality (45 basis points); and savings gluts in emerging markets (25 basis points).
“These factors are not will-of-the-wisp,” he said. “None is likely to reverse quickly. That being so, lower levels of global real rates may persist at levels well below their long-term average. And if so, central banks may find themselves bumping up against the ZLB constraint on a recurrent basis.”
This is where the hard currency constraint comes in. There are a number of undesirable elements for central banks and governments in the world shifting back into hard currencies. One is that monetary stimulus doesn't work so well. Another is the black economy of illicit funds, organised crime and tax evasion still relies on cash – at least for the moment.
Haldane reviewed a number of measures which can be taken to tax or penalise hard cash, from stamp duties to built-in discounts to, intriguingly, new technologies like cyber currencies and the blockchain distributed ledgers behind them.
“Perhaps central bank money is ripe for its own great technological leap forward, prompted by the pressing demands of the ZLB?” he mused.
For Japan, the challenge is manifold. In an essay Japan is sinking in a sea of money, Masanaga Kumakura of Komazawa University argued not only is the BOJ policy wrong, even if it is right, the central bank risks having one of its key confidence tricks exposed: “for the central bank to control inflation, it must be able to control the quantity of money. In the context of the BOJ's ongoing policy, this means disposing of a massive number of Japanese government bonds in a fairly short period of time”.
But to do so, according to Kumakura, investors must be convinced of the BOJ's infallibility, its solvency “otherwise private investors refuse to buy back government bonds, triggering a sovereign debt crisis”.
Kumakura is one of a large band of economists who believe Japan, because of ballooning debt and social security payments for the ageing population, is heading towards insolvency.
And we know from Watto in Star Wars Episode 1: The Phantom Menace, Jedi mind tricks don't work on everyone.
Andrew Cornell is manging editor at BlueNotes
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
27 Jan 2016
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