Bank of Japan 2 — Markets 1

The Bank of Japan’s meeting this week had been hyped up by much of the financial community, which thought the ultra-dove of global central banking might throw in the towel on its policy of “yield curve control”. To remind you all, the BoJ targets the level of the 10-year government bond rate — currently zero plus or minus 0.5 per cent — in addition to fixing the short policy rate at 0.1 per cent. That long-term yield fix had come under market pressure — the BoJ had to buy a huge number of bonds to defend it — through the bank’s unforced own goal of widening the fluctuation band around the yield target last month. As with currency pegs, it was an invitation for traders to speculate against the central bank’s resolve.

In the event, the BoJ did nothing; if anything, it committed more strongly to YCC by announcing some technical tweaks to make it work more smoothly. Those who had bet against it lost; with huge moves down in the 10-year yield and the yen. So if markets had equalised the score with the BoJ since the December meeting — even pushing the yield slightly above the central bank’s permitted band at one point — the bank’s governor Haruhiko Kuroda has now pulled ahead again.

But the debate on whether it makes sense to keep the policy continues. Megan Greene’s recent FT comment sets out many of the economic arguments.

The problem is that most of the commentary I have seen mixes up two very different things: what are the right monetary policy instruments and what is the best monetary policy stance (ie how should the central bank wield whatever instruments it has adopted). So the question of what the BoJ should do with YCC is treated as a matter of whether it is time to tighten. And specifically, many argue from a hawkish point of view: the current monetary policy stance is inappropriately loose (so the argument goes), therefore it is time to prepare for the retirement of YCC.

But if we conflate things in this way, we lose sight of another possible policy development, namely to keep YCC but adjust the targeted yield level upwards when it is right to give less monetary stimulus to the economy. In fact, I think this is the most attractive path of all.

Take the second question first: is it time to tighten Japan’s monetary policy? Recall that Japan has been in a low-inflation (or even deflationary) trap for decades, and getting the economy out of it has been Kuroda’s quest throughout his tenure. With below-target inflation so long entrenched, and with Japan even in the current crisis experiencing weaker price pressures than other advanced economies, surely the BoJ should err on the side of stimulating too much rather than too little.

While there are signs that Japan’s employers and workers may finally have put a disinflationary mindset behind them, the country has seen a false dawn before — a spike in inflation in 2014 proved shortlived. The BoJ’s own forecasts are for inflation to fall below its target again in the next two years. All this makes me conclude that until all actors in the economy internalise long-term expectations for normal inflation, there should be no rush to withdraw monetary stimulus.

But as I have said, the degree of stimulus is a different question from how best to deliver it. So we should assess YCC as an instrument for potentially delivering a whole range of possible monetary stances. Understood as one among many possible central bank instruments, the question is whether it is better suited than the alternatives. And all the signs are that it is.

We should think of YCC as a substitute for quantitative balance sheet policies — that is, targeting a certain quantity of bonds that the central bank should hold. Where other central banks have stuck with “quantitative easing” — buying government bonds to drive down long-term interest in the broader economy — the BoJ has moved to directly targeting the benchmark 10-year rate at the low level it thinks it ought to be, committing to buying as much as the market wants to sell at that rate.

In two ways, targeting the yield itself has worked a lot better than the targeting the quantity of bonds bought, sold or held, which is the strategy pursued by almost every other central bank. (Australia is the one other country that has recently employed YCC. The US did it in the 1940s. All three examples show that YCC is a workable policy tool to be judged on its merits.)

The first is that YCC seems to deliver the desired financing conditions with a much more effective use of the central bank’s balance sheet. The chart below shows the assets held by the world’s three largest central banks, indexed to 100 in September 2016 when the BoJ adopted YCC. (Bear in mind that this does not mean the three had similarly sized balance sheets — the Fed has always absorbed less of its securities markets than the others — but what I am interested in is the evolution over time.) It shows two important things: that the BoJ slowed down its assets purchases when it moved from quantitative to yield-targeting policy, and that it shifted from growing its balance sheet faster than its counterparts to doing so more slowly when the latest crises hit.

Those who worry about bloated central bank balance sheets and the associated money creation should, in other words, prefer YCC to quantitative policies.

The second way in which YCC is superior to quantitative policies is that financing conditions (that is to say, interest rates) in the broader economy are after all what central bankers try to influence. With quantitative policies you have to hope that you choose the right amount of bonds to hold to get interest rates where you want them, and then for that level of rates to get inflation to the right place. With YCC you only have the latter uncertainty; you don’t need to worry that the long-term benchmark rate behaves differently from what you want.

That worry has been serious. One big challenge for most central banks is to manage and communicate their current tightening policies without (a) being second-guessed by markets that offset their policies with contrary asset price moves; and (b) disorderly shifts in long-term yields caused by dysfunctions in market plumbing (see the US’s 2020 “dash for cash” or the UK’s 2022 pensions funds debacle) or self-fulfilling dynamics (see the rise in Italian borrowing costs). Ask this question: if the central banks in those cases had been using YCC, would the disruptions have happened in the first place and would there have been a need for the ad hoc interventions each required? It is hard to see how.

And that shows why YCC should not be seen as monetary loosening, but as an instrument that can work in both directions. Much like lowering the 10-year yield target is a substitute for quantitative easing (buying a pre-determined quantity of bonds), so raising the 10-year yield target is a substitute for quantitative tightening.

So let me give the opposite advice from many others: the BoJ and the Japanese government should not use the imminent change of the guard (Kuroda’s term ends soon) as an opportunity to retire YCC, but rather to normalise it as a regular tool in the monetary toolbox. Narrow the fluctuation corridor again, and take the first good opportunity to show YCC can be used for tightening by raising the target yield. And as I argued two years ago, other central banks should — again — learn from Tokyo: if it works for the BoJ, it could work for them too.

On Sweden and the euro

My newest FT column is on Sweden, which I visited last week to take the pulse on the country now chairing the EU’s ministerial councils. Astute readers will have noticed I didn’t mention the euro; nor did I mention Sweden in my defences of the euro in last week’s column and newsletter. Sweden, of course, is a small open EU economy that has managed very well outside the euro. While it obviously has not avoided a burst of inflation that is international in cause and character, it has not required the punitive interest rates of the central European non-euro countries, and its public finances are among the most solid in western Europe (with public debt about 30 per cent of national income and falling). It seems to be doing quite well with the krona.

And yet. The euro question is not quite dead — though it has long been in suspended animation, as one economist put it to me. At the new year, financier Christer Gardell sparked a debate by arguing in an interview that Swedes were made poorer by having a “shitty little currency”. Gunnar Hökmark, a former MEP, marked Croatia’s euro accession by noting that a country that only joined the EU a decade ago has now come closer to Europe’s core than Sweden. Newspapers have pricked up their ears and started to solicit arguments for and against.

No doubt the stirring is related to the pretty awful performance of the Swedish krona recently, which makes it a good time to come as a visitor but a bad time to be either a Swedish consumer or a Swedish policymaker worried about inflation.

It’s unlikely that Sweden will change its status any time soon. But it is clear that the question is not definitively settled.

Other readables

• The New Yorker asks whether 3D printing can change house construction.

• I found John Naughton’s comment on ChatGPT to be an extremely useful discussion for lay readers like myself of the new machine learning bot that has taken the world by storm. It’s the simplest explanation I have seen of what it does (“next-token prediction”) and makes the important point that the user needs to be knowledgeable to make the most out of it. His analogy with spreadsheet software is enlightening — it makes me note that Excel did not take over the world, but it did make a lot of clerical jobs obsolete.

• Toby Nangle is a fund manager who confronted the philosophical inconsistency between holding certain values of politics or even basic human decency — eg don’t put people in concentration camps or kill and torture your opponents — and managing the financial assets for regimes that do (you know who they are). His FT op-ed on the dilemma and what to do about it is excellent.

• We should prepare for potential energy abundance, not just scarcity, writes Andrew Sissons.

• Martin Wolf interviews Philip Lane, the European Central Bank’s chief economist.

Source: Economy - ft.com