Kuroda's 'Do Whatever It Takes' Pledge Is Less Credible Than Draghi's

Summary

• QQE has failed to deliver acceptable growth and inflation for the BOJ.
• The BOJ re-affirms the centrality of its commitment to QQE even though QQE has failed to deliver acceptable growth and inflation.
• The BOJ has submitted its time consistency for the market to test its commitment credibility.
• The BOJ is simply rationing emergency liquidity injections across different sectors of the Japanese economy on a rotating basis.
• The rising potential growth curve and widening output gap story (“virtuous circle”) is ineffective and needs to be changed.

The developed central banks have entered a delicate phase in their Prisoner’s Dilemma. All have faced the classic commitment problem, of their inability to achieve their goals of economic growth and above target inflation with unconventional monetary policy, in varying degrees.

The signs are that the Fed may have fleetingly achieved the solution to the problem just before President Trump provided it with a global growth problem. The ECB is somewhat behind the Fed, which means that it now risks not achieving the solutions to its problems before the next economic slowdown becomes its priority.

The BOJ seems never to have been able to find the solutions to growth and inflation. It is therefore interesting to see that it has bravely chosen to re-affirm its commitment to solve this problem, when the evidence suggest that it is as far away as it has always been.

When faced with a similar situation to the BOJ, Mario Draghi affirmed the ECB’s commitment, by saying that he would “do whatever it takes”. Draghi however followed through and was thus deemed credibly committed. The BOJ on the other hand has just said that it will do whatever it takes, but then done nothing substantial. In lieu of doing anything substantial it has simply mitigated the negative consequences, for those economic agents in the Japanese economy which are suffering from QQE. The BOJ has only pledged an unlimited time commitment to achieve its inflation. The credibility of this time commitment will now be put to the test.

The BOJ continues to play cat and mouse with its guidance about the potential for further monetary policy expansion or not. The central bank’s recent quarterly assessment of the regions exudes what the BOJ often refers to as the “virtuous circle”. Consistent with said circle, the regions and their inflation are said to be expanding gradually yet sustainably. As Governor Kuroda noted: “Japan’s economy is expected to continue expanding moderately.” The regions are thus giving no signals for the BOJ to either ease further or end the monetary policy stimulus.

Belying the gradually strengthening economic data, there has been a tendency for the BOJ to portray this as sub-optimal and thus no reason to normalise. This Dovish portrayal of the data was recently adopted and embellished by government economic adviser Motoshige Itoh. Mr Itoh recently classified the BOJ as “nowhere near raising interest rates”.

President Trump has also thrown a spanner into the works for the BOJ; and other global central banks not intending to shadow the Fed’s normalisation in general. His broadsides first at the Fed for raising interest rates and then nations that he believes to be currency manipulators poses a real problem for the BOJ.

Unsurprisingly, BOJ Governor Kuroda ducked questions in the immediate aftermath of the Trump attacks. Kuroda preferred to fall back on the default disclaimer that appropriate monetary policy, in light of weak inflation and the threats posed to the banking sector by continuous easing, is still under debate. On President Trump’s assertions about the cause of US Dollar strength, Kuroda passive-aggressively framed the debate in terms of the relative strength of the US economy stimulated by the President’s fiscal policy expansion.

Going into the latest BOJ Monetary Policy Board meeting, there was a great deal of speculation that some change in monetary policy would be signalled. Speculation ranged, from a formal commitment to end QE, to a simple adjustment of the QE process in light of its harmful unintended consequences. The trade off between inflation and these undesired consequences was in particular focus.

For example, the commercial banks had been lobbying strongly to get the purchase of corporate bonds at negative interest rates ended. The impact on inflation from this buying is negligible at best, whilst the negative impact on bank lending and margins is significant. There was therefore an expectancy that the QQE process itself would be tinkered with rather than ended outright.

(Source: BOJ)

The deteriorating global growth and trade picture weighed heavily on the BOJ’s Monetary Policy Board’s decision. In addition, the BOJ did not want to get boxed in by expectations that its tinkering with QQE would amount to a net tightening of monetary policy. Consequently, the BOJ Monetary Policy Board took the step of emphasising the centrality of its commitment to the current phase of QQE. Centrality of commitment is something that central bankers address through guidance.

The tinkering with the product mix of QQE was evident in the meeting’s outcome; as was the guidance to portray this as the BOJ hunkering down for a long-haul attempt to reach its inflation target. The tinkering is aimed at compensating those domestic agents of credit creation who have had their margins and business models decimated by ZIRP/NIRP.

The mix of short-term assets that negative interest rates are applied to was reduced. Some flexible targeting of long-term JGB yields was signalled, but this was framed more as a cap on yields rather than any sign of allowing them to permanently drift higher from current levels. On the qualitative side of the QQE balance sheet, ETF buying will now be skewed in favour of the TOPIX; rather than the Nikkei 225 where the BOJ was running out of things to buy.

The adoption of forward guidance was used to showcase the fact that the BOJ has no intention of following the gradual normalisation course of its global peers at this point in time.

In the short term, whilst the other central banks normalise, the BOJ’s policy stance may look sufficiently easy enough to satisfy its objectives. In a deteriorating global economy, threatened by trade wars and protectionism however, the BOJ’s stance is nowhere near radical enough.

A long-term commitment to ease will look like a tightening, should other central banks start to get serious about easing monetary policy again. The BOJ has effectively put its fate in the hands of its trade partners and its central banking peers. Should the Fed pause or reverse its normalisation course, the BOJ will come unstuck. Should the ECB fail to seize the initiative to raise interest rates, there will be more pressure on the BOJ.

Lost at the end of the BOJ’s statement was its observation that disinflation expectations remain entrenched; and are exacerbated by the rapidly ageing demographic situation. This afterthought was presented as justification for the commitment to stay the course on trying to hit the inflation target. If one asks if anything the BOJ has done will significantly impact the demographic causes of these disinflation expectations, the answer is no.

What was abundantly clear is that there is no commitment to hit the inflation target by a specified date. One wonders if there is really a clear commitment to hit it at all. Only a test of the BOJ’s conviction through an aggressive bout of Yen buying will provide such a test. Selling JGB’s is pointless because the BOJ has capped their yield. Selling Japanese risk assets is pointless because the BOJ will just keep buying them as part of its qualitative easing process. The Japanese Yen is the real medium through which to express a view of the BOJ’s conviction.

(Source: BOJ)

As part of its commitment to more forceful guidance, the BOJ then presented its own analysis of economic activity and inflation trends. Each headwind was dealt with summarily using the mantra that tight labour markets will eventually lead to higher wages; which will then lead to growth and inflation. In BOJ-Speak the rising potential growth curve and widening output gap will eventually revert inflation back to target.

The “Shock and Awe” of the BOJ’s first attempt to unilaterally ease, when the Fed and the ECB were considering tapering, was lacking in this latest initiative. Considering that the previous episode ended in Taper Tantrums, followed by further easing from the Fed and the ECB ,the outlook for the BOJ’s success is inauspicious.

In comparison with Mario Draghi’s famous “do whatever it takes” pledge, the BOJ has adopted a similar centrality of commitment. It has tried to emphasise this commitment by tinkering with the current mix of QQE, to signal that its duration will be extended, thereby necessitating some mitigation for those who are suffering from it.

The BOJ’s credibility depends on the market’s belief in its promise to stay the course. Economic theory believes that, once a central bank has announced its commitment to a policy and the economic agents have adjusted to this, the central bank then has an incentive to renege on its promise. So far the economic agents in Japan do not believe the BOJ, hence its re-affirmation of its commitment to QQE. The BOJ has thus submitted itself for the market to test its time consistency commitment to QQE going forward. BOJ credibility will also be challenged, if and when the Fed and the ECB dial back their own commitments to normalise.

To this author’s eyes, the BOJ is simply rationing the benefits and the pain of unconventional monetary policy throughout the Japanese economy on a rotating basis. As one sector of the polity complains more vociferously, the BOJ responds with pecuniary incentives and remedial actions. Of late it has noted that the banks have been struggling, so it has decided to give them some support.

Using the rubric of the four quadrants, at the beginning of this article, the BOJ is thus acting honestly and dishonestly towards groups within the economy; who also act honestly and dishonestly depending upon how they are performing economically. There is no Pareto improvement to be found anywhere in the matrix. It’s all about the process rather than maximising social welfare outcomes for the nation on aggregate. Japanese economic policy making appears to be a similar process at the elected executive policy maker level. Different sectors of the Japanese polity therefore get their shot of financial support periodically on rotation. The total social welfare function of the whole economy however does not benefit on aggregate. No wonder disinflation expectations remain entrenched and no wonder the BOJ wishes that QQE would make everyone feel rich!

(Source: BOJ)

The most valuable piece of guidance, from the outlook on economic activity and prices report, was to be found in the inflation outlook for 2019. Basically, inflation is expected to head lower. The BOJ has thus signalled that it will play the game of cat and mouse, by appearing to taper for the rest of this year. In 2019 however, at the first signs that its prediction on weakening inflation are met it will start to ease again. By then unfortunately, the Fed and the ECB may already be easing too.

(Source: BOJ)

Masayoshi Amamiya aka Mr BOJ was the first BOJ member, after Governor Kuroda, to project his guidance into the void between now and 2019. It is appropriate for him to do so. It was noted in the last report that he is famous for his consensus building skills. His latest attempt was appositely entitled Japan’s Economy and Monetary Policy. This was very much a domestic focused speech, presumably focusing on those in the audience who are suffering the cost of ZIRP/NIRP.

(Source: Seeking Alpha)

As Mr BOJ pulled back the curtain somewhat, on what had transpired at the monetary policy board meeting, it became clear that he will have his work cut out. From his carefully moderated report it was evident that there is anything but a consensus about policy. Some members would like to see higher yields by way of mitigation for the banks and others who are suffering from ZIRP/NIRP.

The good news for Mr BOJ is that all these fears relate to a common understanding that interest rates cannot rise across the board. There is therefore the kernel of aligned opinion around which to build a consensus. He has between now and 2019 to get a policy consensus fit for purpose. If the gloomy inflation forecast is accurate he has got the data on his side, which should make his job easier. In the end, the process may turn out to be more of the same horse trading and liquidity ration rotating to buy a consensus. Various tweaks, in order to widen margins for the ZIRP/NIRP fatigued, will be traded in order to unleash more of the same ZIRP/NIRP on the Japanese consumer and saver.

The last report noted the BOJ resting rather too heavily on the crutch of a rising potential growth curve and widening output gap dragging growth and inflation higher. This myth was debunked with the observation that Japan’s fictitious potential growth curve is a fiction created to justify the monetary policy stance of standing pat and letting the economy converge upon it. Since the BOJ has abandoned any time limit on hitting its inflation target, the credibility and utility of the mythical potential growth curve and widening output gap are starting to wear thin.

As the real economic costs from ZIRP/NIRP rise and are deliberately mitigated, through interest rate tinkering at the margins, the charade will become even more difficult to sustain. Ultimately, the BOJ will have to concede that its policy is having no meaningful positive impact on the fertility or mortality rate. Said fertility and mortality rates are real and present dangers, compared to the surreal and virtual potential growth curve and output gap. Mr BOJ needs a new story.

Central banker stories, about threats to national security from trade wars, seem to be resonating well in the polities of Japan’s trade partners. The costs of ZIRP/NIRP may be easier to sell to those afflicted, with a patriotic sales-pitch to go with a few marginal interest rate tweaks.

Central banker stories, about threats to national security from trade wars, seem to be resonating well in the polities of Japan’s trade partners. The costs of ZIRP/NIRP may be easier to sell to those afflicted, with a patriotic sales-pitch to go with a few marginal interest rate tweaks. Who knows, patriotism may even nudge the fertility rate!

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.