positive momentum in the economy and markets seen over the last four months.
This kind of contradiction in timing is called the “time inconsistency problem,” and it will continue to hang over the policies of the Kuroda BOJ.
Richard Koo: Implications of lack of synchronicity with private investors
The recent rise in rates appears unlikely to have any lasting effects, but the fact that it happened at a time when the BOJ was buying JGBs in such large amounts is cause for concern. It showed that once inflation concerns start to emerge the BOJ will be unable to restrain a rise in yields no matter how many bonds it buys.
Investors seeking to profit by shorting Japanese government bonds may see this as an opportunity.
It is well known that past efforts by US and UK hedge funds to short JGBs have failed spectacularly.
The reason was that falling government bond yields during a balance sheet recession do not signal a bubble but are a natural result of the absence of private sector borrowers, which causes funds to be channeled into the government bond market. In other words, hedge funds did not realize that this was a “good” decline in rates.
BOJ could be providing opening for short-sellers
This time, however, the financial authorities themselves have said they will use any and all means to generate inflation.
The risk is that this has altered the market structure of the past two decades, in which unborrowed private-sector savings flowed into the government bond market, and contributed to the rise in JGB yields since 4 April.
For the last decade, the BOJ had no need to fear inflation because the money multiplier was negative at the margin. As such, it could respond to hedge fund short selling of JGBs by orchestrating short squeezes with almost unlimited buying.
But the recent rise in interest rates in spite of heavy BOJ buying suggests the BOJ may no longer have that capability.
That may prompt some investors, flush with profits from the yen and Japanese stocks, to set their next sights on the JGB market.
Richard Koo: Question of how to contain “bad” rise in rates is critical
Prior BOJ governors and staffers were all concerned about these issues. Now that the Kuroda BOJ has put the new easing regime into practice, the issue is how to control the risks.
Mr. Kuroda himself says that the accommodative policies have just been launched and that this is no time to be worrying about side effects or exit strategies. However, interest rates have already begun to rise, and in a nation where a “bad” increase could emerge before a “good” increase, the authorities should start preparing for such an eventuality now.
BOJ needs to declare it will not tolerate overshooting of inflation
What can the BOJ do? To begin with, the Bank and the government could make it clear that they are targeting a 2% rate of inflation but at the same time, they will not under any condition tolerate a significant overshooting of that rate.
The Bank of Japan has built up an enviable record as an inflation fighter over the past 30 years and in the process won the public’s trust. Accordingly, I think such a declaration would still carry a lot of weight.
By stating that they will not accept an overshooting of the target, the Bank of Japan and the government could reassure the markets that there will be no plunge in the yen and no bouts of uncontrollable inflation. I think the risk of a sharp rise in long-term rates will also be significantly reduced if the BOJ can successfully communicate these points to the market.
The yen’s rapid decline—which contributes directly to inflation—and stocks’ sharp rise in recent months has raised the possibility of such an overshooting. I think it would be appropriate for the BOJ to consider adjusting the pace of easing going forward in response to these unexpectedly quick improvements.
I think it is also important for the Abe administration to dispel the perception that its scenario for economic recovery is heavily dependent on BOJ policy by placing greater emphasis on the second and third components of Abenomics. If the government is seen as relying excessively on monetary policy at a time when everyone recognizes that the second and third components are essential for a longer-term recovery, the whole enterprise could be stopped in its tracks once monetary policy is perceived as having run up against the wall because of a rise in long-term rates, etc.
And if the Abe government is seen as taking the position that there is no need to pursue the politically difficult second and third components since monetary policy has been so effective thus far, the investors who have led the stock market higher could quickly and collectively become sellers.
Once the second and third components are in place, the positive developments in the broader economy will continue even if a rise in long-term interest rates hinders the effectiveness of monetary policy.
Richard Koo: Growth strategy must also be bold and inventive
From this standpoint, the growth strategy that was partially unveiled by Mr. Abe in a speech on May 17 was a step in the right direction but lacks the “punch” needed to drive the broader Japanese economy.
It is not possible to perform a proper assessment given that the overall vision and the detailed components of the plan have yet to be announced. But what we need now are the kind of bold measures that would make observers stand back in awe, much like Mr. Kuroda’s initial announcement. It is my hope that the strategy will contain such measures by the time it is officially announced in June.
Richard Koo: Active discussion of costs and benefits of quantitative easing in US and UK
Shifting our attention away from Japan, we are seeing active discussion of an exit from quantitative easing policies in the US and the UK in spite of their much higher unemployment rates. Discussion has been driven by the fact that both economies have stabilized to some extent along with concerns that continued use of quantitative easing will lead to unfavorable side effects that outweigh the policy’s benefits.
The IMF recently released a report titled “Unconventional Monetary Policies—Recent Experiences and Prospects” and dated 18 April (the online version was published on 16 May). The report argues that quantitative easing was the right way to respond to the financial crisis but that it had only a limited impact on the macroeconomy and, moreover, that this impact has diminished over time.
This is consistent with the argument we have been making for a long time—that quantitative easing is an
