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Japan and the limits of monetary policy

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By Matthew Thomas
17 Mar 2020

The Bank of Japan (BoJ) has joined a growing number of central banks around the world rushing to solve a problem that is not monetary in nature. Their actions are understandable — but the BoJ offers a clear example of the limits of monetary policy to solve real-world problems.

The US Federal Reserve has cut interest rates by 1.5% in the last two weeks. The European Central Bank, while shying away from cutting rates, has announced its own stimulus measures. The BoJ, always ready to find new tools despite four years of negative interest rates, has doubled a programme to buy exchange-traded funds, pushing it to ¥12tr ($111.3bn).

These moves are certainly understandable. Covid-19 has now spread around the world, causing several thousand deaths and raising difficult questions about how prepared countries are to deal with the problem.

Central banks could not be expected to stand back and watch carnage ripple through the global markets. But to a man with a hammer, everything looks like a nail.

Global central banks have developed their toolkits sufficiently since the financial crisis that they no longer have just one device: they have the sledgehammer of quantitative easing and the precision hammer of asset purchases, among others. But they are still using monetary policy methods to combat a problem that is not monetary in origin.

The coronavirus has already had an impact on macroeconomic indicators. Chinese industrial production plummeted 26.63% in February. Hong Kong tourism fell 96% in the same month. These problems will have a clear impact on their financial markets. But an abundance of liquidity will only address the symptom, not the cause.

Japan offers a telling case study for those wondering how much central bank intervention can do to boost the real economy, rather than just provide a short-term gain for investors and bankers.

Haruhiko Kuroda, governor of the Bank of Japan, has battled huge structural problems — most notably an ageing population — since taking control of the central bank in 2013. It would be unfair to say he has achieved precisely nothing, but most domestic bankers admit that little has really changed.

The BoJ has now proved it has a slightly bigger hammer in its toolkit, doubling ETF purchases and mooting a further move into negative interest rates. These measures may help reduce uncertainty among financial market participants, just as Kuroda has previously been able to make people stop worrying about the ageing population. But they won’t do much else.

Picture this: a family sits at home, doors and windows tightly sealed. They are reluctant to go out into busy streets where queues form for masks, tissues and hand sanitizer. But then they hear the Fed has cut rates by another 100bp!

If you think that will have some impact on their behaviour, you are a true believer in monetary policy. If you don’t, you have little to get excited about. The economic fall-out of the coronavirus, like the problems in Japan, is not something that can be solved with cheaper borrowing rates. At the very least, government spending is needed to supplement monetary easing, as GlobalCapital Asia has previously argued.

There is another, perhaps bigger, problem to the extreme monetary easing we’re seeing at the moment. How do central banks unravel it?

Optimists think the coronavirus will essentially retreat in May or June, pointing to the experience of SARS in Hong Kong and China in 2003. Let’s imagine for a moment that happens. Will the Fed raise rates by 150bp to return things back to normal? Will the BoJ slash its ETF buying programme by half?

The BoJ’s problems also offer warning signs here. Monetary policy changes, whether they work or not, quickly become taken for granted. Global financial markets can be like spoiled children: they might not thank you for the presents you give them, but they’ll certainly scream when you take them away.

None of this is to say that inaction would have been better than action. The Fed, the ECB, the BoJ and their peers around the world will rightly have felt compelled to do something. But their measures may achieve little — and they will prove hard to unravel.

By Matthew Thomas
17 Mar 2020