Two articles today with slightly different messages, but one theme: the similarities between the US and Japan, and the dangers of being complacent.
Most are quick to dismiss comparisons between America and Japan. Two different economic systems and two different policy regimes provide unmistakable sources of comfort for those who might otherwise fear that the US economy could slip into a Japanese-like deflation. The problem with this type of comparison is that it leads to a false sense of complacency. .................
Because America is not Japan and because the Fed now seems to be quick to the trigger in fighting deflation, financial markets have concluded that the battle has already been won. That worries me. A careful assessment of the anti-deflationary responses of the Bank of Japan and the Federal Reserve reveals more similarities than differences in the reactions of the two central banks. Consider the following comparative chronologies:
The Japanese equity market peaked in December 1989. Over the next 15 months, the BOJ continued to push up nominal short-term interest rates before starting to ease in April 1991. Many believe this was the fatal blunder that then led to deflation -- a monetary tightening in a post-bubble climate. Yet the nearly 200 bp increase in the call money rate over this period was nearly matched by a 180 bp acceleration in Japanese inflation that also occurred during this same interval; the year-over-year CPI comparison in Japan went from 2.2% in June 1990 to 4.0% in November 1990. In other words, not fully realizing the severity of what was to come, the BOJ responded to persistent inflationary pressures and pushed up real short-term interest rates by about 20 bp in the early stages of Japan’s post-bubble era. That hardly qualifies as a wrenching monetary tightening.
The Fed’s initial response to the popping of America’s equity bubble doesn’t look all that different than that of the BOJ. The US central bank held the nominal federal funds rate steady at 6.5% for ten months after the equity market crested in March 2000. During that period, CPI-based inflation was basically steady at around 3.5%, implying little change in real short-term US interest rates in the early phase of America’s post-bubble era. In essence, the difference between the initial post-bubble responses of the two central banks is barely noteworthy: The BOJ tightened real short-term interest rates by 20 bp in the first 15 months of Japan’s post-bubble period, whereas the Fed held real rates steady in the first 10 months of America’s post-bubble period. That’s not much of a difference, in my view.
Of course, both central banks finally did see the light. The Fed began easing in January 2001, and over the next 30 months took the federal funds rate down by 550 bp to the 1% level, where it currently stands. Over that same period, CPI-based inflation has receded by about 160 bp from 3.7% in January 2001 to 2.1% in May 2003. That translates into a drop of about 390 bp in real terms. Interestingly enough, as seen in real terms, the results for Japan in the first 30 months of the BOJ’s post-bubble easing campaign are not all that different. The call money rate was taken down from 8.56% in March 1991 to 3.09% in September 1993, a drop of 547 bp. Japan’s CPI-based gauge of inflation decelerated by 209 bp over that same period -- going from 3.6% in March 1991 to 1.5%, 30 months later in September 1993. That translates into a 340 bp reduction in real short-term Japanese interest rates over that same period. In other words, Japan’s easing over that earlier period was not all that different than the Fed’s easing of 390 bp in real short-term rates over the past 30 months.
This comparative analysis raises an obvious and important question: What matters more in assessing the impact of monetary policy -- the level or the change in real interest rates? On the basis of the former, the Fed is clearly the aggressor when compared with the BOJ. It has succeeded in pushing the nominal federal funds rate below the inflation rate at a relatively early juncture in America’s post-bubble era; based on the headline CPI, America went into a “negative real interest rate” regime in late 2002. The BOJ, by contrast, has still not been successful in pushing real interest rates into negative territory..............
The Fed.......... still has some ammunition left -- namely, 100 bp in terms of the nominal federal funds rate. And the US is still running a positive inflation rate. Consequently, unlike Japan today, America still has scope for real interest rate relief. Currently, 30 months after it began its post-bubble easing, the Fed has only 100 bp of nominal interest rate ammunition; by contrast, in September 1993, 30 months after its post-bubble easing campaign began, the BOJ had about 250 bp of nominal interest rate relief left in its arsenal. The Fed currently has more firepower left than the BOJ did at a comparable juncture in its battle. And so I am left with the question: Why didn’t they use it?
Source: Stephen Roach, Morgan Stanley Global Economic Forum
The decision by the Federal Reserve to cut short-term interest rates by a quarter-point last week was a missed opportunity. Share prices may have rallied well since their low on March 11. Signs of a cyclical upswing in the US economy have begun to surface. But the cut was not enough.
The Fed should have committed itself instead to a policy of quantitative easing - expanding the money supply base through market operations - to ensure that long-term interest rates remain low. With a number of economic indicators turning up, there is a risk that the bond market will continue to sell off, driving borrowing costs back up and ultimately short-circuiting the recovery. The next economic downturn could be the one that sends the US into deflation and could raise the spectre of a full-blown Keynesian liquidity trap.
Indeed, John Maynard Keynes always warned that "liquidity preference" among bondholders could be an obstacle to securing the low borrowing costs necessary following an over- investment cycle. Japan's slide into a liquidity trap was aggravated by the failure of the yield curve to flatten until more than eight years into its bear market. For the US, it is the capricious behaviour of bond investors that threatens to undermine the efficacy of monetary policy.
This problem has been self-evident over the past two weeks. The signs of a recovery in the economy were at best tentative and yet 10-year Treasury yields rose by 57 basis points over the period. It is quite possible that the release of the economic data last week does mark a turning point. With mortgage rates falling to a new low of 5.2 per cent and stock prices up 27 per cent since March, it would be surprising if there were not some improvement in the economy over the summer months. But the speed of the sell-off in the bond market highlights the need for some form of quantitative easing.
Comparisons with Japan are instructive. It would seem that the Fed has learnt the lessons of Japan's slide into a liquidity trap....................But there is an even more important lesson to be gleaned from Japan's experience. From early 1992 onwards, successive Japanese governments embarked on a series of fiscal initiatives that backfired. Repeated attempts to reflate caused the yield curve to steepen and blocked the transmission mechanism of monetary policy. The BoJ was too slow in cutting; but the premature use of fiscal policy compounded the mistake. A true Keynesian would have waited until interest rates had reached a floor before the fiscal levers were applied.
Indeed, a second simulation run by Oxford Economic Forecasting has shown that the failure of long-term interest rates to fall quickly was also a critical factor in pushing Japan towards a debt trap. A year and a half after the Japanese government introduced its first fiscal stimulus, the yield curve (10-year Japanese government bond yields minus the discount rate) had steepened by nearly 2 percentage points. If the BoJ had simultaneously initiated a policy of quantitative easing and stopped the yield curve from steepening, deflation could have been averted. Real gross domestic product would have been 8 per cent higher than where it is now. Inflation would have been close to 2 per cent and unemployment would be half the current rate.
In this respect, the lessons of Japan's difficulties have only partially been absorbed. The speed of the decline in short-term interest rates witnessed during 2001 suggests the Fed has been more receptive. But the signs of outright deflation are starting to multiply. The chained consumer price index, introduced to capture substitution effects, shows core inflation is already down to 1 per cent. The US is precariously balanced between price stability and negative inflation. Falling prices started to emerge during the fourth year of Japan's bear market. History is in danger of repeating itself.
There are a number of other reasons why lower short-term rates are unlikely to be enough. Many have claimed Japan's experience could not be repeated in the US because of the differences between the financial systems in these two countries. It is true that a considerable part of the surge in borrowing during the US boom was financed outside the banking system. Corporate bond issuance, in particular, soared. The unwillingness of the banks to lend during the early 1990s was a significant contributor to Japan's slide into a liquidity trap.
But net interest payments by companies have been slower to fall in the US during the first three years of its bear market than in Japan. The "more sophisticated" financial system of the US has left many companies exposed to a rise in risk premiums as defaults have soared. This has in effect prevented lower short-term rates from doing their job. All of this implies the Fed should have adopted a more aggressive monetary policy last week.
Source: Graham Turner, Financial Times