How the Bank of Japan learned to toughen up

How the Bank of Japan learned to toughen up

I.

The psychologist Jordan Peterson, who went viral on social media last week for a tough interview with Channel 4’s Cathy Newman, has an idea about child-rearing.

When raising kids, he says, the worst thing you can do is teach them to be afraid of strangers. He says it’s much better to teach kids to be courageous and strong.

Why? Because courage protects kids from nasty types who prey on the weak. Courage and strength keep kids safe, he says, even if they rarely have to actually stand their ground.

Just the knowledge that a person isn’t to be messed with stops others from taking advantage —the “speak softly and carry a big stick” approach.

II .

What do you know about short term interest rates?

Short term interest rates are the thing central banks change when they’re said to “set interest rates”. When you hear “The Bank of England voted unanimously to raise interest rates by one quarter of a percent”, they’re talking about short term interest rates.

Why does the Bank of England raise and lower interest rates? Basically to heat up or cool down the economy. Raising rates cools the economy which fights inflation; lowering rates heat the economy which fights unemployment.

Perhaps you’re already familiar with all this. But do you know how the central bank literally changes the interest rate?

If you set out to find an answer to this question, Google will lead to a term called “open market operations” (OMOs).

Here’s how the Fed’s website describes them:

“The Federal Reserve [uses] OMOs to adjust the supply of reserve balances so as to keep the federal funds rate – the interest rate at which depository institutions lend reserve balances to other depository institutions overnight – around the target established by the FOMC.”

What this means is that the central bank goes to the commercial banks and buys or sells paper, until short-term interest rates are at the level the central bank is targeting.

These descriptions are basically right; but they’re literally wrong.
But what you won’t find Googling this topic, or on the Fed’s website, is that central banks normally don’t actually do anything to change the short term interest rate.

What happens is this: the central bank announces the change in interest rate, then the interest rate just changes by itself. No open market operations necessary. No buying or selling by the central bank. The commercial banks hear the central banks change their target short term interest rate, so they move to that interest rate all by themselves.

Why do they do that? Why would any trader go against the central bank? The central bank has unlimited power to create money and buy paper; if it wants the short term interest rate lower, it will win eventually. As the saying goes, “don’t fight the Fed”.

III.

Central banks are obsessed with credibility. They need a tough reputation because their reputation does most of the work for them.

No central bank wants to actually have to do all the hard work of printing money, buying paper, and convincing the markets they’re not to be messed with.

Not least because central banks sometimes aren’t as tough as they appear…

Central banks may theoretically be free to print as much money as they want. But in real life there’s politics involved; central banks are controlled by groups of people with differing opinions. They might be able to print as much money as they want, but do they really have the resolve to do so?

Japan’s central bank struggled with this. After its big long recession started in the 1990s, it found itself in uncharted territory. Short term interest rates are the standard tool for warming up or cooling down the economy and in Japan in the 1990s, they were stuck at zero.

With interest rates off the table the Bank of Japan had to try something unconventional: quantitative easing, or QE. QE is a different form of money-printing, a first cousin of open market operations.

The difference is that with QE, the market wasn’t really sure the Bank of Japan “meant it”. It wasn’t sure the Bank could do whatever it took to hit its target, the way it used to be sure the bank would do whatever it takes to hit the short term interest rate target.

The first time the Bank of Japan tried QE was in 2001. It didn’t do a good job…

Instead of committing to a target and going hard until it achieved it, the Bank announced a small QE programme and withdrew it the moment it started to work. The programme, and QE, and unconventional monetary policy in general, was pronounced a failure. And the Bank of Japan lost credibility, making the problem even harder to solve next time around.

That’s the context for Abenomics and Japan’s second big stab at QE, which started in 2013.

This time it’s learned its lesson. The Bank of Japan has shown unflinching determination to hit its target.

And that’s why Kuroda likes to talk about Peter Pan: “I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘The moment you doubt whether you can fly, you cease forever to be able to do it. Yes, what we need is a positive attitude and conviction.”

It’s why the Bank of Japan has had to print an outrageous amount of yen month-in month-out for four and a half years. It’s had to stick to its promise until people take it seriously.

There are signs people are starting to take the Bank of Japan seriously. Deflation is on its way out. Inflation is starting to pick up, albeit not yet at its target rate.

And towards the end of 2017, the Bank of Japan was able to lower long term interest rates by just announcing a new target. No money printing or intervention required.

Such things are possible when you speak softly, and carry a big stick.