On Tuesday, the Bank of Japan left policy unchanged despite cutting their inflation outlook again. The bank’s wait-and-see approach is risky in the face of imminent rate cuts from the Fed and the ECB, which have the potential to drive unwanted yen appreciation to the further detriment of Japan’s inflation targeting effort.
To let governor Kuroda tell it, the BoJ can do more. That’s probably true, but as we wrote in the minutes after the BoJ decision, to the extent monetary policy has limits, those limits are being pushed in Japan.
Whatever ammo is left will be guarded jealously and only deployed if absolutely necessary. USDJPY 108 is no emergency and certainly no cause to fire scarce bullets if you’re the BoJ.
For some critics, the BoJ’s current predicament is a cautionary tale for other central banks.
Rates are negative, Kuroda owns half the JGB market and the bank is sitting on a massive pile of equities thanks to the ETF buying program with no clear strategy for unloading them down the road. And yet, inflation is nowhere near the BoJ’s target.
The domestic economy is ok otherwise, but the broader concern is that soon enough, central banks in all developed markets will find themselves in the same boat as the BoJ: Bumping up against the limits of monetary accommodation and fretting over diminishing returns with each successive round of additional easing.
Meanwhile, easy money and abundant liquidity continues to inflate asset bubbles. Simply put, the transmission mechanism from monetary policy to financial assets has proven to be much more efficient than the transmission channel from asset prices to the real economy.
The fabled “wealth effect” does work, but on a lag. Over time, the excesses in financial markets build up with only incrementally positive effects on the real economy. The result is an ever growing disconnect between financial asset prices and economic gains.
Have a look at the following set of charts from BofA which show that monetary policy is already very loose across developed markets.
In an expansive new note, the bank’s Athanasios Vamvakidis delivers a sweeping assessment of a variety of related topics including what the FX market is saying about the likely effectiveness of monetary policy, the extent to which the global economy is not screaming “panic” and, as alluded to in the visuals, the indisputable fact that conditions are already very loose, even as central banks endeavor to ease further.
One of the main points Vamvakidis tries to drive home is that there’s a need for greater coordination between monetary and fiscal policy. After detailing that argument, Vamvakidis delineates 14 problems with leaning too heavily on monetary policy.
Naturally, not all of the concerns expressed by BofA’s FX team are “new”, but having them enumerated in one place is useful, especially at what might very fairly be described as a pivotal moment for the post-crisis monetary policy regime.
Below is a truncated version of the bank’s list. It is heavily edited for brevity – the full list is much more comprehensive and includes extensive detail and analysis.
- Monetary policy is not always the best policy response and in some cases is just offsetting failures or lack of will in other policy areas to act. The result is a suboptimal outcome, or even worse if the actual cause of the problem remains or even worsens. Central banks act as the “adult in the room,” but this is often far from an ideal outcome.
- Sometimes, central bank easing may even allow worse policies in other areas. The so called central bank put prevents market discipline from forcing more responsible policies in other areas—for example addressing unsustainable debt dynamics. Today’s trade tensions could escalate further if central bank easing continuous supporting asset prices.
- Monetary policy comes across as ineffective and central banks could be losing credibility, as they try to meet an inflation target they may not be able to fully control. We would argue that inflation expectations are low today up to an extent because of a self-fulfilling prophecy, as major central banks have consistently missed their inflation target in the last 2 decades.
- Central banks may be wasting limited ammunition. By responding to inefficiencies and failures in other policy areas, monetary policy is using ammunition that could be more useful when there is a more urgent need in the future.
- Central banks have sometimes ended up micromanaging the economy in recent years, which may have made them less effective in our view. Monetary policy is not panacea and is often not appropriate to address micro problems.
- Central banks have used communication more, to increase transparency and provide forward guidance, as policy room has been depleted, but they may have also gone to the other extreme. Mixed and noisy messages sometimes confuse markets about the actual policy reaction function.
- Further monetary policy easing today could increase risks of a currency war. As both short-term and long-term interest rates are already at historically low levels, the main channel through which central banks hope to inflate their economies is by weakening their currency. However, as most central banks are trying to do the same, they all fail together.
- It leads to mispricing of risks and even asset price bubbles. In the last two decades, monetary policy has affected asset prices more than inflation and inflation expectations. Investors now expect central banks to step in after an equity market selloff and to deliver the cuts that rate markets are pricing. Markets are often guiding central banks, rather than central banks guiding markets.
- The eventual adjustment to fundamentals, most likely in response to an unexpected shock from a blind–spot, could cause an economic crisis. It may be difficult for central banks to identify bubbles, but completely ignoring them, and more so when they are the ones causing them, is another extreme.
- Excessive reliance on monetary policy could reduce long-term potential growth. Keeping borrowing costs too low for too long could lead to misallocation of resources, inefficient investment and excessive risk taking. It could keep “zombie” companies and sectors alive for too long, preventing a creative destruction.
- As central banks are pushed into using more unconventional policies, they end up increasing income inequality. By supporting asset prices, central bank policies benefit particularly the wealthier parts of the population.
- Monetary policy can afford to come to the rescue only because inflation is low. If, however, inflation increases, the room for monetary policy action will become much more limited.
- With more responsibilities comes more power, which could eventually risk central bank independence. As central banks have overextended themselves in recent years, market participants have often called them “the only game in town.” As they become more powerful, politicians may want to control them.
- Central banks overstretching their mandate could face legal challenges, which in turn could reduce the effectiveness of their policies.