Central Bankers Refuse to Learn QE's Obvious Lessons
(Kyodo News via AP)
Central Bankers Refuse to Learn QE's Obvious Lessons
(Kyodo News via AP)
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As the year drew toward its close, policymakers were increasingly confident that their magic elixir of various “accommodative” policies had cured enough ailments to begin seriously thinking about withdrawing them. High on their minds was the idea that such “easing” comes with side effects and costs; the potentially high costs of easing? After so many years and so much of it, officials were getting impatient.

For one big reason, the banks were constantly chirping. No one had complained more than financial institutions, which only raises serious questions about just who has been easily accommodated and by what. Thoughts on these symptoms are, apparently, only for private discussion among authorities.

Regular folks aren’t meant to ponder the details. Central Bank A says it does X, thus accommodation. This easing is made to sound just so super easy on purpose.

The year in question was 2017. Globally synchronized growth and all that. Japan’s central bank had been on the hook for far too long but for once their object was in sight – or so it was believed. Output and labor utilization hadn’t really changed all that much around 2014’s introduction to QQE, but if it had that only would’ve been a welcome side effect itself.

Rather, inflation. Two percent. Monetary easing under QQE was said to be the most awesome and powerful stuff ever conceived by intention, so powerful it bordered upon the insanity of unintentional easing in some cases like Weimar Germany.

Japan, officials had long said, suffered from a “deflationary mindset”, not that anyone thinking this could blame the Japanese people after their experience in the Lost Decade of the nineties. But it wasn’t just a single decade thrown in the trash; the early QE experience of the oughts changed nothing.

Deflation is rightly considered a symptom of underachievement. It is a dastardly monetary disease that infects an economic system by robbing it of its vitality and potential. Money becomes so dear, too dear, that only the most liquid and safe instruments and opportunities are grasped.

In that situation, no economy can flourish. Legitimate, sustainable economic growth absolutely requires risk-taking. We’re often led to think about risk from the perspective of credit loss, defaults and whatnot. In Japan’s experience, and we can unfortunately relate, that’s not what has driven deflationary financial behavior nor would it as 2017 turned to 2018.

Loss in the liquidity sense is equally simple yet either misunderstood or ignored entirely; at least in the academic sense, after all the whole point here is that while academics pay little attention to liquidity risks, survival in any of these marketplaces demands it be taken as the first priority.

Credit risk is the risk of a missed payment – such as in China earlier this week when a troubled real estate developer by the name of Evergrande failed to produce on a scheduled coupon surprising absolutely no one. Liquidity risk, by contrast, is when you think you own a dependable security that makes you think it is dependable because it’ll be easy to sell should the need ever arise.

Therefore, the risk here is far less to do with credit or coupons. The market for a dependable security just might dry up without notice, leaving the security dependable only in terms of its credit characteristics yet forcing you to stare at a potential loss anyway, and maybe even a sizable loss, because there may not be nearly liquid enough buyers for it.

In this systemic situation, very understandably (once made aware) participants would steer clear of this type of uncertainty. Naturally, then, they would limit themselves – absent gigantic returns – to those instruments which actually trade in dependably liquid markets, and even more to those with the very least of questionable reliability.

Whether Japan or elsewhere, for a long time this has meant government bonds.

Given all these things, just what is easing? The textbook answer is a reduced interest cost for borrowers. Sure, that might be one kind of easing, but just what is reducing the interest costs and for which borrowers?

If the issue is systemic liquidity risk, as I described above, then it isn’t some determined central policy which is responsible for lower rates on government debt – that is simply liquidity risks being acted upon in gross (and deflationary) fashion.

Should anyone’s entire perception of “easing” depend upon these same government bond rates, well now we are getting somewhere where it comes to this Japanese “deflationary mindset” in addition to the many others which have come around post-2008.

This is, obviously, the case for current Economic thinking which places special importance upon the “risk free” rate; that is, whichever largely federal government bonds are traded about locally. These are considered in this way because this class of debt has proved free from credit risk.

And if the government bond yield yields for us this risk-free rate, we are meant to presume all other credit risks are priced upon that starting point. This is what Alan Greenspan had claimed during the middle 2000’s about all credit market rates not being independent. The central bank, he said, set the short run and then all the risk-free (series of one-year forwards) for the entire curve which then created the structure for all credit created and traded within it.

This was the same guy who couldn’t figure out why bond yields and interest rates at that time were not behaving in the academic way (“conundrum”).

It is that way which assumes the central bank sets the starting point and all the little pieces just click into place down the line. Therefore, if the central bank says it is reducing rates, it must be “easing” because rates will be reduced for, it assumes, all borrowers.

This becomes only somewhat more convoluted when rates may already be near or at the nominal zero lower bound. In this situation, if the “risk-free” government bond yield is down that far, then, according to the textbook, the next step is to keep the rate at zero (ZIRP) while supplementing the “easing” by then reducing real yields.

The way this happens is, in theory, also very easy. All a central bank would have to do is make the public believe it is increasing its “accommodation”, and since, in theory, the public already believes accommodation is inflationary, this raises expectations for inflation which in turn reduces the real risk-free and effective interest rates in that system.

Straight away, you can easily contemplate the situation described by unnecessarily high liquidity risks (as well as Greenspan’s faulty assumptions). If the “risk-free” rate is already low because perceptions of liquidity risk are high, then this would not appear to be easing by any reasonable definition.

And if not, what of inflation expectations?

More so when this happens in the face of, in direct opposition to, central bank policies which are said to be “accommodative” but do nothing to alleviate these perceptions (often backed by reality) of unusually high liquidity constraints. The direction of interest rates in this situation should be regarded as the opposite of easing.

What are liquidity risks, after all, except the too often appropriate concern from financial institutions that money conditions broadly speaking are insufficient or unreliable? They aren’t necessarily questioning credit characteristics, rather the dependability of being able to price any instrument not just today but should even a small spot of bother crop up unexpectedly.

This is supposed to be the role played by central banks; that’s what everyone says. And you would think these two things go hand in hand – a high degree of easing, meaning lower interest rates in the academic view, which should have something to do with accommodative levels of money supply.

And in the format of quantitative easing (it’s in the name!) or QQE (which appends an additional “Q” for quite revealing reasons), how can it not be all these things? In it, there’s bond buying (raising bond prices) directly easing, there’s a sharp and sustained increase in “base money” (bank reserves) which should easily swallow up all potential liquidity fears now and in the future, both combined can only raise inflation expectations because of the “money printing” going on here, so real rates, too.

When the Japanese got together in November 2017 to debate circumstances and consider any progress toward defeating the “deflationary mindset”, they instead had the banking system all over them openly criticizing policymakers in the media (a big no-no). The “costs” of “easing” were too much. In one article posted by Reuters (BOJ gives early sign of lift-off with warnings on the costs of easing), unnamed bankers were quoted as complaining:

“But bank officials are now more vocal on the rising cost of prolonged easing, such as the hit to bank margins - a sign that their next move would be to roll back stimulus rather than expand it, the people said.”

Yet, if low interest rates were easing as in theory, banks should have been thanking policymakers for filling up their loan books. Rates might have been low and uninspiring, yet easily overcome by gross and profitable volume. While interest costs were low for the Japanese government, this says nothing about for everyone else.

For the first time, those at the BoJ let it be known publicly they were thinking the same as these crabby bankers. Maybe it was time to cut back on the “accommodation” and costly “easing” because it started to look like inflation was becoming a realistic possibility despite real harm caused to financials.

The minutes for that particular policy meeting, held on October 30 and 31 of 2017, show that policymakers were measured in their language and careful in their views. Even then, that elusive 2% target seemed like it was finally within reach (below from the summary of member opinions).

“Medium- to long-term inflation expectations are projected to rise as firms' stance gradually shifts toward raising wages and prices with an improvement in the output gap continuing. As a consequence, the year-on-year rate of change in the consumer price index (CPI) is likely to continue on an uptrend and increase toward 2 percent.”

As Japan’s economy seemed stable even accelerating in 2017, looking ahead to 2018 and 2019 it wasn’t actually the domestic Japanese economy achieving all these good attributes. Instead, as the minutes of that policy gathering disclosed:

“They [members] then shared the view that the increase in exports on the back of the growth in overseas economies was likely to underpin the economy.”

If globally synchronized growth was the true reason for rising potential, what was the point of local “easing?”  Simply to avoid falling further back into deflation. Avoid that, defeat the mindset, and then the global economy can do its thing.

But avoiding more deflation in reality means overcoming very real and very stubborn perceptions about liquidity risk. Instead, QQE had been designed and executed in a way that had nothing to do with actual liquidity and money.

Just three years before all this, in late October 2014, barely a year and a half after introducing QQE, the Bank of Japan voted – out of desperation – to increase its rate of asset purchases. And that additional “easing” barely passed the policy committee on a five to four vote.

In the dissenting faction, there was no disagreement that something needed to be done. Global growth late in 2014 was falling off at an alarming rate (“unexpectedly”). They voted against accelerated QQE because it was reasoned:

“In terms of influence on expectations, some members noted that quantitative and qualitative monetary easing [QQE] had created the effect of changing people’s expectations at the time of introduction, but that additional steps to expand it would only have limited effects compared with when it was introduced.”

You can only fool the public once before the magic begins to wear off; there’s no money in these things, they are all about the “policy surprise” and its supposed effects on expectations. That’s all it is.

And if you are lucky enough, as the Japanese thought in 2017, to have combined somehow plausible long run effects of a long ago expectations surprise with something outside like globally synchronized growth, then somehow this would mean successful policy execution even though there was no actual easing nor accommodation; certainly nowhere common sense.

They might as well have just thrown some darts at a board to come up with random policy prescriptions. Or, as I like (too much) to say, instead of buying JGB’s or ETF’s, why not have the Bank of Japan buy up the clouds floating overhead or the seawater thrashing about off the country’s shores.

Even these Economists and central bankers (same thing) agree that it matters nothing what they buy or what they use to pay for it (not money), they rely solely on the ability to produce this policy shock. Shocking that it never works.

Especially if bond yields and interest rates really are the determined product of heightened liquidity risk perceptions rather than somehow falling in line at the snap of Haruhiko Kuroda’s fingers. Central bank bond buying doesn’t create “easy” rates, a too-high degree of liquidity risk does.

The Japanese would go forward with plans to reduce the “costs of easing” early in 2018, though they never actually got to carry any of them out. Long before, by April, policymakers were slapped in the face by the utter hollowness of globally synchronized growth. In living by export, Japan fell into technical recession by the second quarter of that year as the global economy reversed (Euro$ #4).

Inflation, it needs to be said again, never once came close to its target in Japan and to this day the “deflationary mindset” remains undefeated. And interest rates there are easily low, they’re still not easing.

Hardly the only one, there are so many of these same lessons scattered throughout the QE age available for those policymakers at the Federal Reserve to learn from as they claim to consider these same factors. That, of course, would be too easy.

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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