Ladies and Gentlemen,
Japan was first to use quantitative easing from 2001 to 2006. In early October 2010, the Bank of Japan announced that it would examine the purchase of assets worth ¥5 trillion (around US$45 billion). The programme was expanded progressively to reach ¥101trillion (i.e. 21% of GDP) in December 2012. This relatively small QE programme gradually morphed into a more aggressive intervention (QE3) that began in April 2013 (triggering an annual increase in the monetary base by ¥60-70 trillion (US$545-US$636 billion) and has currently expanded to annual purchases of bonds worth ¥80 trillion (US$727 billion).
1. Japan’s recent monetary policy framework
Last September, the Bank of Japan’s new monetary policy framework came under a new label: “QQE with yield curve control” with the addition of an “inflation-overshooting commitment”.
1. Inflation-overshooting commitment (IOC): The Bank of Japan commits itself to expansionary monetary policy until inflation (defined as the Consumer Price Index excluding fresh food) exceeds the 2% target and “stays above the target in a stable manner”. The target has de facto shifted from a 2% target to a one-sided range above 2%.
2. Yield curve control (YCC), on which there is a US precedent, immediately after World War II and also in 2011-2012 when the US Federal Reserve spent some $667 billion on “Operation Twist” – swapping short-term US Treasury securities for longer-term government debt in an effort to flatten the US yield curve. The goal was to lower long-term interest rates and ultimately spur investment, boost bank lending and the housing market. The yield differentials on 2-year and 10-year bonds shrank to their narrowest in five years. As regards the latter, from 1942 to 1951 the Fed capped the yield on long-term bonds to support government financing during World War II.
The Bank of Japan now explicitly controls the location and steepness of the yield curve. The central bank will set two interest rates: a short-term policy rate and an operating target for long-term interest rates. These rates will serve as guidelines for market operations. The short-term policy rate is presently -0.1%, the same as that applied to policy-rate balances in current accounts held by financial institutions with the central bank. The 10-year JGB (Japanese government bond) yield, set by the central bank, will be the operating target for the long-term rate. Presently, this rate is around 0%. The new policy of targeting a 0% rate on the 10-year bond is designed to steepen the yield curve, thereby providing an incentive for banks to lend. In theory, pegging the 10-year yield at zero would allow the Bank of Japan to steepen the yield curve by taking short-term rates further into negative territory. And the Bank of Japan hopes that a 10-year bond yield at zero will imply that rates on even longer maturities are positive, thereby helping insurers, pension funds and savers.
2. Two comments
Targeting a long-term yield is closely related to quantitative easing, with the difference that pegging a long-term yield essentially amounts to setting a target price rather than a target quantity. At the same time, the Bank of Japan is now flexible to change the maturity mix of its purchases to keep the curve in the desired shape. This policy change has some interesting ramifications.
First, because the 10-year bond was recently below 0%, the move to peg it at zero actually implies a reduced monetary stimulus. The Bank of Japan’s old target of purchases of Japanese government bonds worth ¥80 trillion was partly responsible for the negative yields on Japan’s 10-year bond. Since the goal is now to have that slightly higher rate, purchases can be scaled back. This is a good thing especially considering that the Bank of Japan is slowly running out of bonds to buy. But this move to rate targeting also puts the Bank of Japan in a precarious situation because rate targeting involves potentially unlimited purchases and sales of bonds. The Bank of Japan must now effectively work against global investors and offset their money flows into long-term government bonds. In Japan’s earlier monetary policy framework, the purchase of JGBs was specified by “the amount of increase in the amount outstanding of JGBs held by the Bank.” But since the purchase amount was fixed, its impact on long-term yields varied depending on financial market conditions and a reading of the economic situation. However, since the central bank is trying to control the yield curve, it will purchase JGBs in order to “achieve the target level of interest rates specified by the guideline for market operations at the time.” This would mean that the pace of its purchases may change in order to ensure that the yield curve remains at the level that the central bank deems appropriate.
Second, the new inflation target commitment. One of the key features of Japan’s new monetary policy framework is its inflation-overshooting commitment. The Bank of Japan intends to expand its monetary base until inflation goes above its price stability target of 2%. For the first time, no time-frame is set for inflation to move to that level. The Bank of Japan’s inflation-overshooting commitment is based on observed rather than forward-looking inflation, thus becoming backward-looking.
3. Monetary policy going forward – exiting low and negative interest rates
Exit strategies are more difficult when unconventional monetary policies are implemented for a more extended period. The longer UMPs stay, the more difficult exit strategies are. It is worth reminding that Fed’s tapering started in 2013 and almost three years later the Fed increased its interest rates on 16 December 2015 by a mere 25 basis points and since then of course 10 months have passed until a second rate rise (which appears probable by 80%) next month, so that we can talk about a monetary policy normalisation that is unfolding. Exit strategies necessarily depend on country-specific circumstances, including decisions on the sequencing of tightening when various measures are put in place. With respect to QE, central banks may simply allow purchased assets to mature, which would result in a gradual normalisation of the size of its balance sheet over several years. More importantly, the ability of central banks to pay interest on reserves allows them to raise policy rates despite having large balance sheets and thus provides additional flexibility in formulating exit strategies. An exit from unconventional monetary policies presents several challenges. First, policy-makers need to allow for the possibility that concurrently raising policy rates and draining reserves might alter the usual transmission mechanism. A typical policy rate increase, for example, could prove less contractionary than usual in the presence of substantial excess liquidity in light of expanded balance sheets. Second, if the central bank needs to sell assets, it could incur losses. To preserve policy credibility and independence and ensure future policy effectiveness, it needs to clearly state accountability in the context of exit. AS far as the Bank of England is concerned, the UK government provides an indemnity to cover any losses arising from the asset purchase facility. The US Federal Reserve, meanwhile, would stop remittances to the US Treasury should it incur losses and would need to offset losses with future remittances. We can only imagine the bad press what such losses resulting from their shrinking balance sheets could mean for the central banks on top of the criticism that the four major central banks are already subject to as a result of their prolonged unconventional monetary policies.
With regard to this last point, I would like to raise a rather topical question of if and how the concept of an independent central bank has been challenged, or perhaps even undermined, in an era of unconventional monetary policies including their exit strategies.
My own verdict is that the challenge should not be in the very concept of independence but rather in the current economic policy mix: loose monetary policy plus tight fiscal policy. By keeping interest rates in negative territory for too long, namely the redistribution effects of monetary policy and the perceived degree of success of meeting the mandated objectives become more pronounced.
All in all, an independent central bank that is subject to democratic accountability needs broader support from the public. Clearly, with persistent negative rates you are bound sooner or later to lose major parts of the broad constituency that you need as an independent central banker.
Finally, one last word about the ECB’s exit strategy. Despite last September’s rumours in financial markets about a potential tapering, ECB Vice-President Constâncio has emphatically denied this last month and clearly the evidence is on the ECB’s side. Despite eight years of non-standard monetary policy measures, inflation is stuck at historically low levels and there are few signs of a sustained rise in nominal demand. Inflation was 0.4% in September (flash estimate). Core inflation stood at 0.8% in September, well below the target level of 2% for more than 5 years. Inflation expectations lie around 1.4%, as measured by the 5-year inflation-linked swap rate. Let me just remind you that inflation expectations stood at 1.7% just prior to the start of the PSPP in March last year. The latest Survey (fourth quarter of 2016) of ECB Professional Forecasters showed declines in inflation expectations for 2016 and 2018. As a result, inflation is expected to be 0.2 per cent in 2016, 1.2 per cent in 2017, and 1.4 per cent in 2018. In short, there is ample evidence that any discussion for the ECB’s exit strategy from unconventional monetary policy is rather premature at the moment and the prevailing case is for caution.
Thank you very much for your attention.
*Speech made in Tokyo (Japan) on 21 November 2016 at the Japan Center for Economic Research (JCER)-OMFIF conference “Abenomics and the Japanese economy”, in Session II entitled: “The effects of the Bank of Japan’s quantitative and qualitative monetary easing with negative rates”.