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Japan: Long Live ZIRP!
Takehiro Sato (Tokyo)
The Deflation Threat Goes Global
Restricting its rate cut to 25 basis points at its June 24-25 FOMC meeting, the Fed seems to have avoided an early entry into a zero-interest-rate (ZIRP) environment. The accompanying statement, however, noted that “the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level” and “on balance, the Committee believes that [deflation] concern is likely to predominate for the foreseeable future.” Therefore, the statement went farther than the May FOMC statement in highlighting deflation concerns. While the statement did not mention unconventional easing measures, contrary to market expectations, I expect the Fed’s reference to possible deflationary concerns to fuel renewed market speculation regarding additional rate cuts and unconventional easing measures, although these concerns have been reduced by the Fed’s action last week.
Rather, the basic situation is becoming similar to that in March 1995, when the BoJ was confronted with a severe backlash to its smaller-than-expected rate cut, in the form of extreme yen appreciation and a sharp decline in equity prices. Similarly, the Fed recently received its own baptism by fire in the form of the sharp rise in Treasury yields. The Fed seems to have avoided an entry into a ZIRP environment based on its knowledge of Japan’s economy and financial markets. However, raising long-term interest rates carries the risk of reversing the positive recent shift from housing investment to personal consumption, which has effectively been holding up the US economy, something which the Fed cannot afford to ignore. In my view, US monetary policy looks set to slide toward long-term interest rate-targeting via verbal intervention. Looking further ahead, since much of the efficacy of monetary policy is nullified by deflation, and deflation looks to hit the US sooner or later, I personally still see a sizable risk that the central bank will slip into ZIRP in order to combat deflation.
ZIRP, however, is a very unconventional policy, with many negative side-effects. In Japan, ZIRP has not only failed to achieve its original goals, but may have even contributed to deflationary concerns. For example, Japan’s experience with ZIRP demonstrates that central bank influence becomes limited after easing short-term rates to zero in a deflationary environment. Furthermore, the outcome of ZIRP in Japan called into question the effectiveness of unconventional easing in general. While the BoJ’s unconventional easing initiative succeeded in containing systemic risk initially, its policies have since preserved excess supply without thought for the effectiveness or purpose of such excess capacity. Such a policy has drawn domestic banks into an inescapable predicament.
In this context, there are several prerequisites for such an unconventional policy to work effectively. US monetary authority stresses (1) preemptive and proactive policy decisions, (2) overcoming balance sheet problems in the banking sector, and (3) policy support to encourage risk-taking, which are important factors in the battle against deflation when short-term interest rates approach the zero boundary. However, in my view these measures are not enough. Depending on how unconventional monetary policies are implemented, they can foster severe moral hazard and paralyze any effort of policy reform. Then the policy turns out to be a kind of trap from which it becomes increasingly tough to escape. I believe the following are the main lessons from Japan’s experience with ZIRP:
(1) Do not set the policy rate near 0%.
(2) Do not erase long-term yield volatility.
(3) Do not make an overly difficult policy escape rule.
Long Live ZIRP!
Japan has encountered several surprises in the first-ever central bank experience with ZIRP. We describe below the lessons learned after Japan moved into the ZIRP environment. Above all, the liquidity provided by the BoJ’s Rimban purchase operations merely lowers the credit multiplier and does not expand monetary aggregates, since the banks’ credit-creation function is disabled. Therefore, Rimban operations do not increase asset prices or the expected rate of inflation. Instead, they preserve excess capacity, and lead to extreme yield-curve flattening and deflationary expectations. Also, equity prices do not benefit from a risk-free rate too close to 0% under ZIRP, because deflation raises the risk premium and lowers corporate growth expectations: Deflationary expectations are reinforced in a self-fulfilling manner, and corporate growth expectations decline with the rise of the risk premium. Moreover, expectations of home currency appreciation (a strong yen) through higher real interest rates (the “forward discount bias”) complicate efforts to achieve sustained yen depreciation under ZIRP. Once the economy falls into the ZIRP policy trap, market expectations for the continuation of ZIRP increase in a self-reinforcing manner. This encourages yield curve flattening and an uneven distribution of market risk, which makes it almost impossible to retreat from a zero interest rate commitment under these circumstances.
I believe Japan has fallen into this policy trap due in part to untested crisis management. The dangerous nature of ZIRP manifested itself when the Koizumi administration’s double standard of advocating structural reforms while actively expanding the employment safety net by impairing banks’ shareholders capital deepened the policy trap.
Policy Game Is Over After Policy Rate Hits 1% Range
The Fed appears to have successfully avoided the risk of being trapped by ZIRP; however, the policy game was already over when the federal funds rate was trimmed to around 1%. This has not changed in spite of the recent retreat regarding additional easing: The job of the central bank is still to fight deflation. Moral hazard similar to that experienced by Japan is an inevitable corollary, in my view, should the monetary authorities commit to a given long-term interest rate level. The nature of Japanese ZIRP seems almost designed to create moral hazard, but it also brought an unexpected policy trap.
Grasping the nature of ZIRP, one must understand that the recent global rebound in long-term interest rates is nothing but a reversal of the position following the puncturing of excessive expectations. In Japan’s case, a variety of unfortunate conditions have ultimately combined to result in the evaporation of the yield curve. Market participants already understand that the curve will evaporate so long as deflation continues, despite the recent sharp rise, and they are hoping to stave off the inevitable for as long as possible in order to build up attractive positions. The recent trend in the JGB market has been in line with such expectations from market participants. So don’t worry, be happy!
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