In an earlier 2019 research project, the question asked was what it would take for negative interest rates to ‘go global'1. It was put this way because any prospect of negative interest rates wakes everyone up given its impact.
The question could instead have been asked another way, as is done below - 'Why is it now so hard to avoid Japanification'? Here, it is not so much about negative interest rates per se but about the Japanese experience of a very prolonged period of near zero or negative interest rates, alongside zero inflation or deflation.
Japan entered these conditions first a long time ago, and it is the prospect of the Japan story being replayed many times over looking ahead that so haunts central bank corridors today.
The opinion piece below argues that for a complex mix of factors, avoiding Japanification is getting much harder. It is not inevitable, but the measures that will tackle it have big drawbacks and risks.
The Japan Parallel
Japan got there first. After a large financial bubble from the late 1980s burst, interest rates had to be cut sharply, the policy rate falling below 1% in early 1995. It has not moved much from there in the past two and a half decades. With interest rates stuck at low or near zero levels in the past decade in Europe, the UK and even the US, it is no wonder that those with a keen eye for historical parallels see the specter of ‘Japanification’ looming more globally.
But Japanification came with deflation right the way through this period – the average inflation rate was zero in the 1995-2019 period, but this conceals over a decade of outright deflation. Not even Europe has had sustained deflation. On interest rates, though, the Japan parallel matches much more visibly. Europe, UK and the US have been turning Japanese for many years. US interest rates were lowered to 0.5% in 2008 and stayed there for about 8 years. Rates did get above this during 2016-18 but all hell broke loose when rates went above 2% in late 2018 so they have once again been cut to a much lower level. The market sees rates going still lower. The UK, has had a similar fate, with bank rate holding at well under 1% for over a decade now, no attempt at monetary normalization, and the market seeing the bias to be still lower rates which will last for many years. Sound Japanese? As for Europe, well, the market’s assessment is that rates are now stuck near indefinitely at zero or slightly negative levels, Japanese style.
How did rates and yields get so low - everywhere?
Now take bond yields (gilts, treasuries, bunds, etc). These are ultimately an average expectation of a policy interest rate for the term of the bond. In earlier times, yields incorporated an element of risk from unexpected developments in inflation or policy interest rates (sometimes called a duration premium, or bond risk premium) but this notion looks almost quaint now. These days, investors pay the bond market for the privilege of taking duration risk. Why? Essentially because the demand for bonds has for many years exceeded supply, given the sheer amount of bond buying that has occurred (and continues to) from just about everybody – central banks, commercial banks, insurance companies, pension funds, wealthy investors and even ordinary households in the US. This is almost entirely price-insensitive buying, providing you with a very good explanation for the disappearance and eventual inversion of the duration premium.
Supposing the supply shortage remains the same (no worse, no better) looking ahead. Then things become straightforward. Yields will then reflect a view of what central banks will do with interest rates. And here central banks face big problems in fighting the long-term trend towards lower and lower interest rates. For this trend is at least three decades old. It dates, whether coincidentally or not, from Japan’s troubles at the start of the 1990’s. A complex interactive motion of many factors – demographic, debt accumulation, the productivity/investment slowdown, and regulation post financial-crisis has pushed much of the world on this slippery downward interest rate slope. Seen this way, Japan may just have been an early and extreme example.
One-sided interest rate inertia
This multi-decade trend is just very hard to challenge. Whether it is Europe where the move to outright negative interest rates is already five years old, or the UK, which has been locked into what looks like a milder version of the rest of Europe, or the US, where trying to take interest rates a bit further away from zero back-fired so spectacularly in 2018, one thing is so very clear. It is the invidious asymmetry in rate moves – it is always easier to cut rates than raise them at the best of times - but this time around, it is just far harder. Whether macro conditions are driving economies towards lower sustainable interest rates, or the shrillness of financial markets to even the threat of rising rates, or the lurking fear of what rising rates will do to high and rising debt burdens, really does not matter. It is probably a bit of everything. What matters is that this is an interest rate slope that is incredibly hard to stop slipping down, let alone climb back up. Also, the longer you stay at ultra-low rates, the harder it is to raise thereafter – a kind of acute one-sided interest rate inertia which is the real essence of Japanification.
No deflation, so why the alarm?
Are we then all destined to Japanify? On the inflation side of it, at face value, no. Even Europe has not experienced anything like Japan’s zero inflation average and the UK and USA still less so. As we know, deflation makes it far more likely that rates must go to zero levels (or even lower) for the simple reason that if you do not do this, ‘real’ i.e. after inflation interest rates, tend to rise, a form of monetary tightening, perverse in a weak growth environment.
If Europe, UK and US are not experiencing deflation why then worry about Japanification? The answer is that average inflation is falling over time, so that the direction of travel is not reassuring. Pre-financial crisis, Eurozone inflation averaged 2%, but it has struggled to go much over 1% since – and 1% is just not that far from the zero average and bouts of deflation that Japan has seen for such a long time. And the US trend is no different, just at a slightly higher level than Europe. On the US central bank’s inflation measure, inflation keep falling short of the 2% target; the last decade average is about 1.5%, with the trend still down. Only the UK shows no obvious long-term trend towards lower inflation – is this an exception that proves the rule? It may have been on its way to establishing a lower inflation trend in the 2012-15 period but then the Brexit-led fall in sterling arrived, masking the underlying trend in inflation.
The bottom line is that we cannot rule out growing Japanification risk, even on the ‘inflation going to zero’ criterion. Since the interest rate picture is already matching Japan, the unfortunate take-away is that Japanification remains a present and clear threat. While zero inflation and bouts of deflation makes Japanification far more likely, the fact that we have not seen this so far is a flimsy basis for arguing that Japanification is a remote possibility.
A fiscal challenge to Japanification?
What about the challenge to Japanification from a big fiscal stimulus that shifts the burden of supporting economic activity away from central banks? Recently much talked about, even drawing a recent urge on fiscal stimulus from the ECB President, so much so that I was recently told that talking about Japanification was now just so ‘yesterday’. Is this the big hope that Japanification can be avoided? The idea is that massive fiscal stimulus will be used to fight the next downturn, allowing central banks to avoid using their limited interest rate tools available. Seen this way two things happen. First, rates do not then have to go towards zero or lower in the ‘hold-out’ countries, most notably the US. Second, if you issue lots of bonds to finance stepped up government borrowing, the current supply shortfall will ease, ending the three-decade trend towards lower yields. It is only a short step from here to argue that such fiscal stimulus will raise yields – bond supply increases, the market begins to worry about inflation again, and hey presto, yields move higher.
The reality is a bit more complicated than that. First, it is not clear that fiscal stimulus, or enough of it at any rate, will come from anywhere. While low interest rates are a spur towards bigger deficits as it lowers borrowing costs, if deficits and public debt are already high and rising (as seen through most of the developed world and now many emerging economies too) this is not great for making the case for running larger borrowing levels because public deficits will automatically rise in any downturn anyway. As for the few countries – (everybody looks at Germany) who do have fiscal space to borrow more, will they be agreeable to a big fiscal expansion when deficits are already on the rise? Possibly, but you can sense my doubt. More to the point is that when you think about it, central banks are very unlikely to be allowed to get away with sitting and twiddling their thumbs in any big economic downturn, especially with fiscal room limited.
It is actually very likely that if rates can be reduced, they will be. Some cannot cut rates very much at all – as there are logical limits to how negative rates can go (though the limits may be lower than one normally imagines). Everywhere, it is likely that more QE will be restarted to supplement limited rate cutting capacity. But here is the problem. The business of issuing more bonds to finance deficits and doing QE just looks like what was happening for most of the past decade – did yields fall or rise during this period? Can we also really imagine that the demand for safe assets will fall? No.
Bigger policy shocks needed – ‘Helicopter money’
To really move the dial meaningfully towards rising interest rates, much bigger policy shocks are needed. Very large deficit financing could do the trick, but what could potentially move the dial away from Japanification much more is for this to be financed directly by a ‘helicopter money’- type mechanism. Here, cash or spending vouchers are directly distributed to households, with no repayment required, i.e. they are irredeemable. This will stimulate spending. It will also take you away from Japanification. Why? Because it will both stimulate the economy and bring back the disappeared bond risk premium in markets. Inflation concerns will surface – both domestic through pushing up demand in the economy from households spending their free windfalls and because the currency will likely fall (unless it was being done on a similar scale by others too). Because politicians might get a taste for it, and because it undermines independent central banking (cash liabilities created by the central bank do not have assets attached like QE) it might well do the trick and raise yields. It should also feed through to higher policy interest rate expectations too and take you even further away from Japanification, on the view that policy rates will have to rise eventually to pull inflation (or inflation fears) lower.
Does this amount to saying that only helicopter money has the potential to truly defy Japanification? Yes, probably. But is the heavy price worth it given the risks and is it all too much of a tall order for governments to even attempt? Probably. After all, even Japan has not really done helicopter money and you can understand why2 . Even quantitative easing, far less risky and not open-ended as helicopter money, is now widely seen as having had too many unintended side-effects, and with marginal value at best in delivering more growth or inflation. Dealing with helicopter money could unleash rather bigger side-effects or dangerous accidents, even if it averted Japanification. This does not stop it being attempted, but the hurdle for it to be started and to be successful without too much of a price to pay is high.
Not inevitable, just hard to avoid
Japanification going global is not inevitable. But there has already been a very long creep towards it. Avoidance at this late stage is getting that much harder.
2 Japan did consider launching a helicopter money initiative in 2016 but was reportedly persuaded by Ben Bernanke, then Chairman of the Federal Reserve that the attendant risks would be too great.
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