Demographics - The Central Bankers' Nightmare

Updated January 2018

In 2017, former Federal Reserve Chairman, Ben Bernanke, gave a pep talk to the Bank of Japan, discussing the nation's monetary woes.  As those of us that have been paying attention know, Japan's economy has suffered from a multi-decade period of mediocrity with deflationary pressures present despite the Bank of Japan's best efforts to stimulate inflation and reverse low economic growth rates.  In this posting, I want to look at some of his key points and explain why I think that the Bank of Japan, like the Federal Reserve, is doomed to monetary policy failure.  

Let's open by looking at two graphics; one showing the population pyramid for Japan, a graphic which shows the age distribution issues facing Japan:

As you can see, there is clearly a dearth of younger Japanese supporting an aging population, an issue that is causing significant problems for the nation's economy.

Here is a current population pyramid for the United States:

While that doesn't look particularly threatening, here is a projected population pyramid for the United States in 2056:

As you can see, in four decades, the situation has changed significantly with the U.S. pyramid starting to resemble the bottom-light pyramid of Japan, although, not quite as bad thanks to a higher birthrate among some people groups in the United States.  The further out that we go, the worse the situation looks with fewer and fewer young Americans supporting more and more older Americans, in large part because of the dropping birth rate as shown here:

Now, let's start the main part of this posting by looking at what the Bank of Japan has done to stimulate its economy:

As you can see, the Bank of Japan has had an extended period of near-zero interest rates going all the way back to  the mid 1990s.

Now, let's look at what Ben Bernanke recommended for the Bank of Japan in the early years of the new millennium, prior to his term at the helm of the Federal Reserve and while he was still an academic:

"I argued that central bank purchase programs should focus on longer-term assets and not be concentrated on bills (i.e shorter term government securities), as had been Japanese practice in earlier forays into quantitative easing.  I made the point, associated with Reifschneider and Williams (2000), that in the face of deflation risks it was important not to try to conserve policy ammunition but to move “decisively and preemptively” (Bernanke, 2002). I emphasized the need to set an inflation target high enough to provide some buffer against deflation, and I noted that temporary overshoots of the target to compensate for prior inflation shortfalls could be warranted following a period in which rates are constrained by the effective lower bound.  I frequently acknowledged the need to complement monetary policy with fiscal and structural measures and cited the critical importance of assuring financial stability through lender-of-last resort actions, financial regulatory reform, and bank recapitalization."

Here's what he had to say in hindsight about his recommendations:

"However, I certainly did not get it all right. In particular, in earlier writings I was too optimistic and too certain about the ease with which a determined central bank could conquer deflation, and I had little patience with the alternative view. For example, in a 2000 paper written while I was still an academic, I criticized the Bank of Japan for its “self-induced paralysis” and for showing insufficient “Rooseveltian resolve.” I asserted that more-aggressive policies would certainly yield better results, as Franklin Roosevelt’s unorthodox strategies seemed to do in 1933, and, indeed, as Minister Takahashi Korekiyo’s policies did in Japan during the same period. But when I found myself in the role of Fed chairman, confronted by the heavy responsibilities and uncertainties that came with that office, I regretted the tone of some of my earlier comments. Central banks do have viable options at the effective lower bound, but the problem has proved less tractable, in both the United States and Japan, than I had suggested. In particular, in some of my early writings, I did not always demarcate sharply enough between what monetary policy can achieve on its own, and what requires some degree of coordination with fiscal policy (i.e government-led stimulus spending).  At a 2011 press conference, in response to a question from a Japanese reporter about my earlier views, I responded, “I’m a little bit more sympathetic to central bankers now than I was ten years ago.” Why ending deflation and escaping the effective lower bound has proved tougher than I once expected will be one of the themes of my talk today."

His conclusions about the Bank of Japan and what should happen on a going-forward basis?

1.) The Bank of Japan should continue to pursue its goal of 2 percent inflation because it will restore economic stability in the future by restoring the ability of monetary policy to respond to future economic contractions.

2.) Since 2013 and the election of Shinzo Abe, the Bank of Japan's policy of quantitative and qualitative easing (QQE) has been implemented policies which, interestingly, included purchases of exchange-traded funds (i.e. the stock market) and private assets, the Bank of Japan's balance sheet has grown to about 88 percent of Japan's GDP at the end of 2016 compared to 24 percent for the Federal Reserve and 34 percent for Europe's ECB.  While this has had some benefits to the Japanese economy, it is unclear whether the Bank of Japan will actually be able to meet its objectives since much of the economic response "...depends in part on factors outside of the central bank's controls".

3.) If (and it appears that the Bank of Japan has already passed the point of no return on their policies) current policies are insufficient, Japan needs a program of both fiscal and monetary co-operation in which the Bank agrees to increase its inflation target temporarily to offset increased government spending or tax cuts to prevent the nation's debt-to-GDP from rising any further.  Since Japan's debt to GDP is already well passed the danger zone at more than 200 percent of GDP, this could prove to be problematic.

One significant issue facing the Bank of Japan is its massive balance sheet.  Here is a table showing the massive size of the Bank's assets:

Using a conversion rate of 111 Yen to the U.S. dollar, the Bank has a balance sheet totalling $4.54 trillion (U.S. dollars) with 85.5 percent of that being Japanese government securities as shown on this graphic:

While this is only slightly higher than the Federal Reserve's current balance sheet in dollar terms, it is a far higher percentage of the entire Japanese economy as shown here:

While we (and I included Mr. Bernanke in the collective), may think that the Bank of Japan's struggle to right Japan's sinking economic ship may be a unique situation, as the population pyramids at the beginning of this posting show, the demographic changes facing the United States and the other developed economies of the world mimic (in large part) those of Japan.  While Mr. Bernanke may be full of ideas on how the Bank of Japan should handle Japan's economy on a going-forward basis, demographics are proving to be a central bankers' nightmare and no amount of monetary policy creativity will be able to reverse the structural changes in the world's developed economies that are associated with an aging population and lower birth rates.  

The New Economic Normal and the Impact on the Federal Reserve

A recent speech by Eric Rosengren, President of the Federal Reserve Bank of Boston, gives us a glimpse of what may lie ahead in the world that is the Federal Reserve.  In his speech, he outlines why it will be necessary for the Fed to implement one aspect of its new monetary policy ammunition and why this will be necessary.

As we all know, the Fed and its most influential peers have kept interest rates at historically low levels for the longest period in history as shown here:

Obviously, when the next recession hits, the Federal Reserve will have very little room to drop nominal interest rates, particularly when looking at how much rates dropped in the past as shown on this table:

In real terms (i.e corrected for inflation), the Federal Funds Effective Rate has been in negative territory for the longest duration since the 1960s as shown here:

Mr. Rosengren notes the following:

1.) with today's ultra-low short-term interest rates, there will be a limited buffer for monetary policy to respond to economic slowdowns (i.e. central banks have not got sufficient room to lower interest rates as they have in the past). 

2.) real short-term federal funds rates are likely to be negative more frequently.

3.) nominal federal funds rates are likely to reach zero more often (and in my opinion, may become negative).

The economic problem that the Fed has faced since 2008 is structural rather than cyclic in nature, that is, the functioning of the economy has transformed in a manner that is permanent.  In other words, very little of what the Fed has done since the Great Recession has been effective because the Fed's policies are designed to deal with cyclic (temporary) changes in the economy.

Here are two examples showing how the economy has undergone structural changes:

1.) Productivity Growth - Change in non-farm real output per hour:

2.) Civilian labor force growth rate (i.e demographic changes):

So, what's a central banker to do when the next recession arrives?   Here's a hint:

The world's three most influential central banks have massively increased the nominal size of their balance sheets because they discovered that, in the wake of the Great Recession and the nature of the post-recession economy, simply lowering interest rates were "...insufficient to rekindle economic growth..."

Here's the same data as a percentage of GDP showing how desperate the situation is for Japan, a nation that has undergone the most profound demographic changes:

Mr. Rosegren states that "...structural changes in the macroeconomy may necessitate more frequent use of large scale asset purchases during recessions.  This latter view hinges on the argument that the combination of low inflation, low rates of productivity growth and slow population growth may imply an economy where normal or equilibrium short-term interest rates remain relatively low by historical standards, even once the economy has fully normalized."

As I've noted in the past, central banks have painted themselves into a policy corner from which there is no easy extrication.  Never before in modern history have central banks acquired such a massive inventory of assets and never before have they faced divesting themselves of these assets.  No one understands the market implications of unloading and offloading trillions of dollars worth of bonds, and yet, Mr. Rosengren suggests that expanding central bank balance sheets is the only way to stimulate a contracting economy in a low interest rate environment.  Keeping in mind that the world's central bankers didn't see the looming Great Recession until it was on the doorstep, we should be concerned that the repercussions of their remaining monetary policy tool is unproven.

Let's close this posting with Mr. Rosengren's concluding remarks:

"While the extensive use of central bank balance sheets has been a distinguishing feature of the most recent downturn and slow recovery, I see it as quite likely that this tool will be necessary in future economic downturns. Unless productivity growth and demographic trends change, or monetary policymakers set a higher inflation target, the feasible reductions in short- term rates to combat recessions will not be sufficient. Thus, monetary policymakers are likely to need to use balance-sheet tools.

If monetary policy is to rely primarily on short-term interest rates to normalize policy, as seems prudent given the historical experience, in my view the Federal Reserve should adopt balance sheet exit strategies that reinforce the primacy of interest rate policy. Starting to shrink the balance sheet earlier – and doing so in a very gradual fashion – implies very little reduction in the degree of monetary stimulus coming from the U.S. central bank’s balance sheet. This, in turn, will allow policymakers to focus on gradual increases in the federal funds rate target as the primary mechanism for normalizing monetary policy and calibrating the economy." (my bold)

Good luck with that, Mr. Rosegren. 

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.