Japan’s Monetary Policy – Thoughts on Speech at BOJ by Ben Bernanke ( Part 2 )

Here is part 2 on the traditional central bank mechanisms and how it has evolved with the ongoing environment. Please find part 1 here


“Although Japan’s economy is growing only slowly, that largely reflects longer-term forces, notably a shrinking labor force and slow productivity growth, factors which are not amenable to monetary policy” (Bernanke’s BOJ Speech, pg 4)

It is true that Japan’s labor force has been shrinking, evident by the decline in population from 128m in 2010 to 127m in 2015. This trend is expected to continue as the death rate has exceeded the birth rate starting from 2006 and has widened since then. As many in the economics would say, monetary and fiscal policy are neutral in the long run from a full employment position. What this means is that both policies can’t create organic growth, it can only serve as policies that reflate back prices and growth. They are catalyst for growth, not drivers. A central bank that implements expansionary monetary policy would inevitably have to contract back as it needs to keep inflation in check. A big fiscal program with tax breaks for a long period is not sustainable because it inevitably has to be funded by taxpayers money, and consumers would just expect that a tax break now would mean a tax increase in the future.

Data from Japanese Statistics Department


“Under Governor Kuroda, the Bank has adopted a policy of so-called quantitative and qualitative easing (QQE), including purchases of exchange-traded funds and other private assets as well as of Japanese government bonds.”

The reason why I picked this quote by Bernanke because it highlights the changing nature of central bank functions and mechanisms. Central banks conventionally and traditionally influence the economy by adjusting its key interest rate and acting as a lender of last resort to banks.

The first point of “adjusting interest rates” means that a central bank typically sets an interest rate that produce the full employment of the economy. Full employment here means that growth is maximised at a level of stable inflation.

If an economy is undergoing recession, a central bank would decrease interest rates to increase consumption, investment and exports. The decrease in interest rates would send signals to banks under its supervision to decrease their deposit and lending rates, which in turn encourages savers to hold cash ( lower deposit returns ) and businesses to lend more ( lending rates are lower). Decrease in interest rates would also lower the yields on the country’s government bonds, driving investors out of the country’s bonds for higher yields. This in turn decreases demand for the country’s currency and depreciates it. The depreciated currency theoretically improves export competitiveness as domestic goods are cheaper to foreign countries. When an economy is overheating with high growth and high inflation, a central bank would raise interest rates to decrease consumption, investment and exports. As is the case, savers would save more as deposit rates are higher and businesses would lend less as lending rates are higher. Government bonds becoming more attractive as yields are higher and this appreciates the currency which in turn leads to decreased export competitiveness.

Central banks also have the role of being the lender of last resort for the purpose of financial stability. Financial stability can be aptly described as the smooth working of the financial markets which connect savers and investors. This means that investors and borrowers can have access to financial markets for funding and liquidity purposes. For example, when the 08 financial crisis hit the US in 2008, banks were unwilling to lend to anyone including bank peers for fear of exposure to the mortgage debt crisis. A central bank like the FED can step in and extend short term loans and liquidity to the banks that require it, in which the FED was ready to do.

But one of the big stigmas in the financial industry is that you only go the central bank when all else has failed and institutions or banks that do, normally suffer a loss in reputation. So what the FED did was to do an indirect policy of reducing the interbank rates, which is the rate at which banks borrow to each other. This made it cheaper for banks to extend short term borrowings to each other without suffering a loss in reputation.

Much of traditional monetary policy lies in the mechanism of the central bank setting a key interest rate to influence the other key rates like deposit, lending, bond rates and others. This in turn influence behaviours of consumers and businesses. So how is the “policy of so-called quantitative and qualitative easing (QQE), including purchases of exchange-traded funds and other private assets as well as of Japanese government bonds” differ from the traditional mechanisms and why is it being implemented now?

The question of how it differs lie on why it is being implemented now. Remember the context that banks were unwilling to lend to anyone in the 08 crisis. This was because financial institutions had a collapse in the mortgage asset market and were experiencing huge losses to their P&L and balance sheet. Funds that were available for consumers and businesses in the debt and loan market dried up as many banks pulled back on these funds to recuperate their losses. Traditionally, when faced with these situations, central bank would step in and provide emergency short-term liquidity measures to ride out this period until banks get their operations and books in place. The key role here is that banks need to have sufficient liquidity to keep financial markets operating smoothly until they are able to recover. Because the financial crisis in the markets have potentially severe implications on the real economy and there was an ongoing stigma on central bank lending, the FED decided that a more radical measure needs to be implemented in the form of QE. What the central bank does in this case is to purchase in high amounts not just short-term government bonds, but long term government bonds and private assets to directly put money in the hands of the banks, businesses and consumers. So if you hold a $100 government bond which you bought at $90 ( 5 year zero coupon bond ), the central bank would offer to buy the bond at $98 now. The FED would “print” $98 of money to be deposited in your account in exchange for that bond. You would have cash $98 ($8 profit) now to spend vs $100 in 5 years from now.

This is also true for banks and businesses with the assets that the central bank wants to purchase and that includes the mortgage assets that went sour. In a way, this is a bailout of financial institutions which have exposure in the mortgage-backed assets but not all assets were bad to begin with. It was a certain class of sub-prime mortgages that threatened to spill-over to the other sound assets when you securitise them together. Through this, the central bank sent a signal to the markets that they mean business in terms of restoring liquidity.

I just went through a bunch of stuff explaining central bank mechanisms and how it has changed to the situation now. How does this tie in to Japan? As you have known, Japan has been through a Lost Decade, deflationary environment with low growth persisting since 1992. Interest rates were actually very low and near the zero bound but that has not produce the high growth environment before 1992. Krugman in his papers describe that Japan is stuck in a super liquidity trap where low interest rates do not influence consumption, investment and exports that much. Richard Koo is of the opinion that Japan is stuck in a balance sheet recession, in that consumers and businesses are more inclined to pay down debt than to consume and invest. The traditional mechanism of using the key interest rate to influence other key rates and indirectly business and consumer behaviour is to a certain extent, broken. This large scale purchase program signals the mechanism that Japan wants to implement, that is to directly put money in the hands of businesses and consumers.


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