by Bill O’Grady and Kaisa Stucke
[Posted: 9:30 AM EDT] In the wake of the BOJ and Abe disappointment yesterday, we have been observing a steady backup of long duration yields. So far, this isn’t anything too serious, but the market narrative behind it is important. There is a growing concern that BOJ monetary policy may have reached its limits. In terms of rate adjustment and QE, it probably has. Once a central bank becomes the dominant buyer of the entire yield curve, sovereign debt probably ceases to be a market and the central bank becomes the sole determinant of all rates, not just short-term ones. According to reports, BOJ Governor Kuroda is starting to receive pushback from some board members, suggesting that he will struggle to expand the balance sheet further.
However, it is probably a mistake to limit the possibility of policy to merely QE and rates. There are other policy tools available but the ones left are controversial. The first option, which we have discussed at great length, is helicopter money. However, this policy would require fiscal authorities to work directly with the central bank to accomplish anything. If the government is too timid with fiscal expansion, the impact of direct financing of fiscal spending is potentially minor. The second would be aggressive devaluation; imagine QE with foreign bonds. The goal here would be to drive down one’s exchange rate to boost exports and constrain imports. Such “beggar thy neighbor” policies, seen in the 1930s, are considered inappropriate now but, if conditions deteriorate enough, consideration of such actions cannot be discounted. The problem with this policy tool is that it is dependent on foreigners to acquiesce to the policy, which is unlikely. Trade retaliation and capital controls would be potential responses.
One common element to both of these controversial measures is that there will almost certainly be strong opposition from central bank policymakers. The possibility that a government could propose massive fiscal expansion only to see the central bank balk on funding it directly is a real possibility. This is why we took note of a Bloomberg article reporting that Kozo Yamamoto has joined Abe’s cabinet as Minister of Regional Revitalization. Yamamoto is a strong advocate of radical measures to combat Japan’s secular stagnation and one of his ideas is to strip the BOJ of its policy independence. Last year, Yamamoto was quoted as worrying that the BOJ was wavering on its commitment to monetary stimulus and Governor Kuroda might be contending with “a den of conspirators.”
Central bank independence has not always been considered best practice. The Federal Reserve didn’t become independent until the 1951 Treasury Accord. The BOJ didn’t become independent until 1998. On the one hand, there is an argument to be made that it makes sense for a central bank to coordinate policy with the fiscal arm of the government to make it more effective. If fiscal spending and monetary policy work at cross purposes, it can make fiscal stimulus less effective or lead to ineffective inflation control. On the other hand, since fiscal policy is affected by politics, central bank independence is put in place to act as a bulwark against inflation. Simply put, if the goal is inflation control, central bank independence is a key component. If the goal is reflation and the escape of secular stagnation, central bank independence is a hindrance.
Giving Yamamoto a stronger voice could lead the BOJ to simply become the funding arm of fiscal spending. Another news item we noted last night was that North Korea launched a ballistic missile that landed near Japan. It isn’t hard to imagine a massive defense spending expansion, funded directly by the BOJ, which is under the supervision of the Ministry of Finance. So, we would caution that the idea that central bankers are out of tools may not be true. Yes, further measures would require fiscal coordination but that could be accomplished. The key issue is that we have, over the past 36 years, built a policy consensus that is designed to keep inflation under control. Brexit, Trump, Sanders and perhaps Yamamoto all suggest that this policy consensus may be coming to a close. If that is the case, rising inflation somewhere in the medium term is increasingly likely.