Negativity's End: Japan & Central Bank 'Disarmament'

The world may be out of the negative bond yield hole sooner than you think.

Just a few days ago, commentators were portraying the world economy's future as one of never-ending declines in interest rates as central banks the world over experimented with zero interest rate policies (ZIRP) or, if those didn't work, negative interest rate policies (ZIRP). To encourage lending, borrowing and investment--or depress the value of one's currency, it's been left largely unsaid--they had to resort to such extreme measures since, well, everyone else was doing it.

However, there has been an obvious problem with this argument: what if these negative interest rate policies didn't generate any appreciable additional economic activity, let alone sustained growth? This precisely has been the problem of the Bank of Japan (BoJ). Widely expected to take interest rates further into negative territory as its meeting concluded a few days ago, the BoJ instead stood pat and handed the baton to PM Abe and fiscal policy. While it is equally doubtful whether massive government spending can life Japan out of its moribund state: 

The Bank of Japan (BoJ) Friday passed up the chance to increase its monetary stimulus, as many market observers had expected, and instead just tinkered around the edges with some token adjustments. Not only that, but it also called for a review of the impact of its extraordinary monetary policy on economy and said it will debate the issue at the next Monetary Policy Meeting (MPM) on 20-21 Sep. Is Japan, the first country in the world to adopt zero interest rates and quantitative easing, now signaling that monetary policy has reached its limits? 

The fault according to the Japanese lies in not enough folks believing that inflation will happen. Absent such conviction, it doesn't happen as a self-fulfilling prophecy:

What is that transmission mechanism? The paper included the following flow chart. Note the central role of inflation expectations. This ties in with BoJ Gov. Kuroda’s “Peter Pan Principle,” which he stated in June 2015. “I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it,’” he told a BoJ conference. “Yes, what we need is a positive attitude and conviction.”

The line of reasoning is as follows: if people think that prices are headed higher, they will demand higher wages. Companies will pay higher wages and then raise their prices to cover those higher wages. Then more people will ask for wage hikes. Result: inflation!

Yes, well, that's how it should have worked out in theory. Given that hardly anything has gone Japan's way, the BoJ is conducting a "comprehensive assessment" to be released September 20-21. In the meantime, the knock-on effect worldwide is that if Japan does not drag everyone else further into NIRP territory to maintain competitiveness, then there is no reason to expect even lower interest rates going forward. While the Bank of England has cut rates to record lows in an effort to ward off a UK recession post-Brexit vote, it is not going into negative territory according to Governor Mark Carney:

One of the most controversial strategies has been to push interest rates below zero, a tactic deployed by the European Central Bank and the Bank of Japan. But on Thursday, Carney ruled out the possibility that the BoE would follow suit, putting the “lower bound” for rates as slightly above zero. In a news conference, Carney also dismissed questions about so-called helicopter money — in which the central bank directly finances government spending — as “flights of fancy.”

The evidence from Japan and Europe is that negative rates have not generated much economic activity since:

• Savers are hurt by low rates of return, instead encouraging them to hoard more cash instead of spending it;
• Investors do not necessarily borrow more when there are few opportunities despite lower borrowing costs; and
• Financial institutions are hurt by compression in borrowing and lending spreads collapsing.

Who benefits? Maybe no one.

Having led us to this strange place, will Japan and Europe lead us out of it? If the evidence continues to point to ZIRP leading its main proponents nowhere, then there is little point for them to continue. What's more, their failed experiments will signal to other countries that this game is up. What will eventually happen is, yes, the return of positive rates even in these regions. In an interconnected world economy, that means higher yields the world over than what we have at the present--but not much higher unless economic growth is jump-started somehow. All we know is that ZIRP doesn't achieve this objective. 

UPDATE: Also see this FT commentary on central banks beginning to admit defeat.