IS THERE a rational explanation for the meltdown in global financial markets in the past month? Headlines have focused on uncertainty over US interest rates, after the change of leadership at the US Federal Reserve. But another, even more important, change in the global monetary environment has attracted less attention: the change in monetary policy at the Bank of Japan.
To the extent that easy money has been responsible for driving up global asset prices, the main source of this excess liquidity has not been America but Japan. In the past five years, the Bank of Japan has not just kept interest rates at zero but also flooded the markets in Tokyo with 30 trillion yen (roughly $300 billion) of excess reserves every night. This policy expanded Japan’s money supply to the same level as America’s, in an economy only one third the size — and much of this money has flowed abroad, resulting in ultra-low interest rates and rising asset prices around the world.
Just over two months ago, Japan decided to end this policy of “quantitative easing” — and the ripples from the country’s draining liquidity have been felt around the world. But this was only the beginning of Japan’s monetary transformation. At some point soon, a second shoe will drop: the Bank of Japan will start raising its overnight interest rate, which has been pegged at zero since 1998.
A steep rise in Japanese interest rates, with many analysts predicting a rise of as much as 2 per cent in the next 12 months, is arguably the biggest risk to financial markets in the year ahead. The good news is that, after spending a week in Tokyo, talking to politicians, businessmen and financial officials, I returned with a strong conviction that market fears are exaggerated on this point.
There are three reasons for believing that Japan’s short-term interest rates will remain near zero for another year or so and, even more importantly, that they will not rise above 1 per cent for the rest of this decade. The first is that policymakers in Tokyo have been saying quite explicitly that they would wait for some time after the end of quantitative easing before moving interest rates, in part to give banks the chance to learn how to operate in the new liquidity environment.
Since excess reserves in the Tokyo money market last week were still around 14 trillion yen, the end of quantitative easing seems to lie several weeks ahead. The BoJ’s preferred game plan seems to be to start with a quarter-point rate hike in the autumn and only to bring the overnight rate to 0.5 per cent by the end of the Japanese fiscal year next March.
This assumes, however, that the Japanese economy continues to grow steadily and financial markets do not fall out of bed. This is beginning now to look like a quite demanding assumption and points to a second reason for believing that Japanese interest rates will stay lower for longer than most investors expect.
While Japanese domestic demand will probably continue to grow quite robustly throughout this year, the US economy is now palpably slowing and Europe soon will follow suit. This will tend to strengthen the yen and weaken Japanese exports and, under these circumstances, the BoJ will probably want to avoid anything more aggressive than a 25-basis-point rate hike this year. Why, then, should the BoJ raise interest rates at all?
The most plausible answer is simply that “free” money, lent out by the BoJ at a zero rate, is fundamentally unhealthy in a market economy. Zero interest rates were justified by the extraordinary weakness of the Japanese economy, but everyone in Tokyo now agrees that more normal conditions should gradually be restored. But what would be a “normal” interest rate in Japan? This question points to the third and most important reason for expecting interest rates to remain below 1 per cent for a very long time.
The equilibrium interest rate in a normally functioning economy is roughly equal to the growth rate of GDP. GDP, in turn, consists of two components — the long-term potential growth of the real economy growth and the trend rate of inflation. The BoJ believes that Japan’s potential growth in the years ahead will be 1.5 per cent and 2 per cent, with the labour force shrinking by 0.5 per cent every year, while productivity grows by 2 per cent to 2.5 per cent. Meanwhile, prices are still on a falling trend. The BoJ’s “core inflation” index, which excludes food but includes oil prices, is now rising by 0.5 per cent and this has allowed the BoJ to declare victory in its war against deflation. But if oil prices were excluded from the core Consumer Price Index, as they are in America, inflation would still be negative. More importantly, the GDP deflator, a price indicator which measures broader movements in industrial costs as well as consumer prices, is still falling steeply — at an annual rate of 1.5 per cent.
Thus Japan’s 1.5 per cent to 2 per cent potential growth rate would translate into nominal growth of between 0.5 per cent and 1 per cent, implying a natural interest rate of 1 per cent or below, at least until next year.
And what happens in 2008 and beyond, when Japan’s deflation may be truly over? By that time a new justification for ultra-low interest rates will come into play.
In April 2008, the Japanese Government will almost certainly start imposing very significant tax increases to narrow its enormous budget deficits. The only real debate in Tokyo today is over whether the consumption tax, which is currently at 5 per cent, should rise to 10 per cent immediately in 2008 or whether the pain should be spread over several years. With luck, raising taxes will prove less disastrous in 2008 than in 1997. But Japan’s policymakers will not want to take any chances.
If they set interest rates too high, Japan will relapse into recession, deflation and fiscal catastrophe. If they keep interest rates too low, the worst that might happen is an uptick in inflation, which would simply bring Japan into line with other countries.
The choice is obvious: Japanese interest rates will remain “surprisingly” low for many years to come. And these low interest rates, in turn, should continue to underpin surprisingly high prices in global financial markets.
