Monday, February 13, 2017

The Federal Reserve's Reluctance to Learn from the Bank of Japan

Updated March 15, 2017

I recently posted an article on the minutes from the Federal Open Market Committee meeting held on November 1 and 2, 2011, focusing on who was to blame for the intransigence of the American labor market (hint - it was the drug-abusing, lazy unemployed that were to blame).  Digging further through the 282 page release, there was more interesting information, particularly the Fed's concerns that the U.S. economy may be retracing the steps that the Japanese economy has experienced over the past two decades despite the central bankers' best efforts.

Let's look at some background information to start.  Here is a graphic showing the timeline for Japan's experiment with Quantitative Easing between 2001 and 2013 as well as the growth in the monetary base and consumer price index:

In general, quantitative easing entails the purchase of assets (i.e. government bonds) by a central bank which is financed by money creation.  Effectively, the government is printing money rather than raising taxes or cutting expenditures to pay its debt; as a result, QE is considered to be inflationary.  With Japan's ultra-low inflation rate, QE was expected to raise inflation/eliminate deflationary pressures, however, as the above graphic shows you, that has clearly not happened.

Here is an updated graphic showing the Bank of Japan's balance sheet from Yardeni Research with the QE periods shaded in blue:

As of February 2, 2017, the Bank of Japan held a total of 481.98 trillion yen ($4.31 trillion US) on its balance sheet as shown here:

This is what has happened to the yield on 10-year Government of Japan bonds since 1989:

This is what has happened to Japan's GDP growth on a year-over-year basis since 1995:

Over the past twenty-one years, Japan's GDP has grown at a very modest average of 0.32 percent per year.

From this background, we can see that the Bank of Japan's mammoth sixteen year effort to kick-start the Japanese economy with a succession of monetary experiments has been less than a resounding success with low inflation and low economic growth all while punishing savers with ultra-low interest rates on their investments.  

Now, let's look at some excerpts from the FOMC minutes.  

1.) President Charles Evans - Federal Reserve Bank of Chicago:  After advising that the Federal Reserve revert to a "business as usual" monetary policy model by removing excess monetary accommodation, he notes that the United States could end up with a "liquidity trap" scenario where injections of cash into a low interest rate system by a central bank fail to decrease interest rates because consumers choose to avoid bonds and keep their funds in short-term savings with the belief that interest rates will soon rise.  Here are his quotes:

"The second story line I referred to as the “liquidity trap” scenario. In this scenario, short- term risk-free rates are zero. Actual real rates are modestly negative, but the real natural rate of interest is strikingly negative. This is due to an abundance of risk aversion, extreme patience, and deleveraging, and these attitudes are unlikely to disappear any time soon. In this scenario, we’re in the aftermath of an enormous Reinhart–Rogoff financial crisis, and the resulting drags on demand are exceedingly large and persistent. The clear and present danger here is that we repeat the experiences of the U.S. in the 1930s or Japan over the past 20 years...

According to the logic of the liquidity trap theory, we risk being mired for an unacceptably long period in recession-like circumstances unless we are willing to voluntarily embrace and commit to a higher inflation rate than our medium-term objective, at least for a time. It is against central bankers’ DNA to discuss and acknowledge this, but we should not risk an outcome like the U.S. in the 1930s or Japan today. Three percent just isn’t such a big number that we should resist it the way the 1930s Fed adhered to the gold standard." (my bold)

2.) President James Bullard - Federal Reserve Bank of St. Louis:  Here are his comments on changing the Federal Reserve's inflation target, whether a higher inflation target is warranted and whether the Fed could retain its credibility if it changed its target: 

"As you all know, I remain concerned that we are not putting enough weight on the possibility that committing to near zero rates for a very long time will simply produce zero rates for decades. The memo contemplates very long times at a policy rate of zero. It really begins to sound like we would be creating the worst outcome of all and the importing of the Japanese situation to the U.S. We should be thinking about the tradeoff between possibly creating a replication of the Japanese situation in the U.S. versus the relatively minor and uncertain benefits of promising longer and longer times at a policy rate of zero in the hopes that that would raise inflation expectations today...

If that policy rule is going to tell you that you’ll never move off zero until certain conditions are met, then the public starts to think, okay, you’re never going to meet those conditions, so you’re going to stay at zero. One of the conditions is that inflation is near target, but because of the Fisher relation, inflation expectations are low, and so you’re just permanently below the target. That’s what happened in Japan, where they’ve had mild deflation for 15 years." (my bold)

3.) President John Williams - Federal Reserve Bank of San Francisco:

"Finally, Governor Raskin and I are just back from a trip to both China and Japan, but I’ll comment on what we heard in Japan that made me especially drawn to the Tealbook “Lost Decade” alternative simulation. In fact, many of the people we talked to in Japan predicted that the U.S. would soon, or within a few years, be talking about a lost decade for the U.S. In this scenario, “persistently sluggish growth . . . has a corrosive effect on the supply side of the economy.” Governor Raskin and I encountered people, as I said, who warned that these risks were developing for the U.S. And based on their own agonizing experience, they stressed the difficulties of pulling an economy out of a protracted slump. The large downward revisions to U.S. potential that I mentioned earlier reinforce such concerns." (my bold)

4.) President Charles Evans - Federal Reserve Bank of Chicago:  Here is a comment that he made during his regional update:

"To sum up, all of the incoming data and anecdotal reports point to an economy that’s just sputtering along. We’re generating growth, but it falls far short of the pace we need given the size of the resource gaps that must be closed. With regard to the two scenarios I discussed this morning, in my opinion, the U.S. economy is entangled in a liquidity trap with amplification from a large Reinhart–Rogoff financial crisis. We could be staring at a lost decade, the way President Williams was suggesting from his comments on Japan. Even if this is only an exaggerated risk—I don’t think it is—if we fail to take further actions, owing to credibility risks, we end up with about as much credibility as the Bank of Japan has, I worry. Like President Rosengren, I worry about too slow, incremental policies. I think we need to continue to add more accommodation." (my bold)

My suspicion is that, when the Bank of Japan announced its first foray into quantitative easing back in March 2001, it had no idea that sixteen years later, it would still be undertaking monetary policies to reflate its moribund economy and that more than a decade and a half of monetary policy experimentation would have proved so ineffective at achieving more than modest improvements.  For obvious reasons, the Federal Reserve should be very concerned that it is retracing the steps of the failed Japanese monetary experiment, concerns that were quite evident in the minutes of the FOMC meeting held in November 2011.  Despite those clearly expressed concerns, the Fed went on to implement QE 3 in September 2012, hoisting the its own balance sheet to its current level of just over $4.2 trillion and has now the Federal Funds Rate at or very close to zero for over eight years as shown here:

Apparently, the Federal Reserve is not capable of learning the lessons that history teaches. 

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