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.  

Ben Bernanke on Negative Interest Rates

Now that the Federal Reserve has made another tentative and infinitesimally small increase in its benchmark interest rate, a blog posting by former Federal Reserve Chairman, Ben Bernanke, takes a fascinating look at what may lie ahead for the Fed, particularly when it comes to negative interest rates, the monetary policy choice-of-the-day for some of the world's most influential central bankers.  Let's take a look at the rationale that he uses to defend his position on the use of negative interest rates as part of the Fed's arsenal of monetary weapons.

Firstly, Mr. Bernanke notes the following:

"Nominal interest rates are very low, and in a world of excess global saving, low inflation, and high demand for safe assets like government debt, there’s a good chance that they will be low for a long time. That fact poses a potential problem for the Federal Reserve and other central banks: When the next recession arrives, there may be limited room for the interest-rate cuts that have traditionally been central banks’ primary tool for sustaining employment and keeping inflation near target."


It is this exact "monetary policy corner" that is creating the need for the Federal Reserve to change its modus operandi when it comes to the next recession.  Some Fed insiders like John Williams and Eric Rosengren have suggested that the Federal Reserve raise its target for inflation upwards from its current level of 2 percent and suggest that the use of negative interest rates should be a last resort.  Here's what Mr. Bernanke has to say about that approach:

"...negative rates and higher inflation targets can be viewed as alternative methods for pushing the real interest rate further below zero. In that context, I am puzzled by the apparently strong preference for a higher inflation target over negative rates, at least based on what we know now. Yes, negative interest rates raise a variety of practical problems, as well as political and communications issues, but so does a higher inflation target. In this post, I argue that it’s premature for policymakers to emphasize the option of raising the inflation target over the use of negative rates. Pending further study about the costs and benefits of both approaches, we should remain agnostic about whether either or both should be part of the Fed’s policy framework."


Mr. Bernanke goes on to observe that the Federal Reserve has routinely set the real federal funds rate at negative levels (i.e. when the nominal federal funds rate is lower than the rate of inflation).  Assuming that the Fed will not set the federal funds rate at negative levels, under the current inflation target of 2 percent, the Fed cannot reduce the real policy rate below -2 percent (i.e. a zero nominal rate minus the 2 percent inflation expectation).  If the Fed wanted to lower the real federal funds rate further, it would have to lower the nominal federal funds rate into negative territory or raise the inflation target or both.  For example, with an inflation target of 4 percent in a zero-percent nominal interest rate environment, the real federal funds rate could be as low as -4 percent.   Given that inflation has done this since the beginning of the Great Recession, raising the inflation target is a non-starter:

As such, Mr. Bernanke goes on to provide four reasons why he believes that negative interest rates are preferable to a higher inflation target as follows:

1.) Ease of Implementation:  The Bank of Japan and the European Central Bank have imposed a negative interest rate policy and in their experience, the action is instantaneous and spreads rapidly to other interest rates and asset prices.  To enforce a negative interest rate policy, the Fed could simply impose an interest rate charge on banks who chose to keep their reserves with America's central bank.  In contrast, imposing a higher inflation target would not increase the Fed's ability to lower the real interest rate unless consumers' and corporations' inflation expectations changed as well.  Changes in inflation expectations tend to be respond very slowly in prolonged low inflation environments like those that exist today.

2.) Costs and Side Effects:  Negative interest rates can cause profitability problems for the banking/financial sector and money market funds, particularly in a long-term negative interest rate environment.  This is critical since the successful implementation of central bank monetary policies requires a healthy banking sector.  On the other hand, higher inflation can result in financial stability risks including reductions in the value of bond portfolios.  This is a particular problem for the financial sector including pensions and insurance companies which have traditionally held long-term bonds as part of their portfolios.

3.) Distributional Effects: An environment of negative interest rates would affect wealthier households and corporations while the financial sector may be less likely to pass on negative rates to small depositors.  On the other hand, it would benefit debtors including mortgage holders.  A higher inflation environment would be harder on less wealthy households who find it more difficult to shelter themselves from higher costs of living and holders of bonds who would suffer a capital loss.      

4.) Political Risks:  Both policies would be politically unpopular; Mr. Bernanke notes that this could lead to:

"...reduced support for the policies of the central bank and for its independence. In particular, as already noted, the credibility of a higher inflation target could be reduced if political support for it were seen to be tenuous. Political viability is thus an important concern in judging these policy options."

With the expectation that negative rates would be a short-term phenomenon that is used only during economic emergencies, this approach may be easier for the public and politicians to swallow, however, as Japan and Europe are showing us, negative interest rates show little sign of abating and politicians in both jurisdictions do not seem to be suffering from this recent phenomenon.  On the other hand, a higher inflation target would be seen as a long-lasting change that is not restricted to an economic emergency; in this case, approval or review by Congress may be necessary.  

With all of this in mind, here is Mr. Bernanke's conclusion:

"It would be extremely helpful if central banks could count on other policymakers, particularly fiscal policymakers, to take on some of the burden of stabilizing the economy during the next recession. Since that can’t be assured, and since the current low-interest-rate environment may persist, there are good reasons for the Fed and other central bankers to consider changes in their policy frameworks. The option of raising the inflation target should be part of that discussion. But, as I have argued in this post, it is premature to rule out alternative or potentially complementary approaches, including the possibility of using negative interest rates." (my bold)

Both negative interest rates and higher inflation targets would give the Fed more room to manoeuvre during future recessions.  Obviously, Mr. Bernanke currently favours a negative interest rate policy over an increase in the inflation target as a future means of extricating the Federal Reserve from its current "monetary policy corner".  While Ms. Yellen has, so far, been reluctant to implement a negative interest rate policy, as we all know, one should never say "never" when one is a central banker.  As the post-Great Recession period has shown us, central bankers are only too willing to fly by the seats of their collective pants when it comes to creative and experimental monetary policy implementation.  As well, the Federal Reserve's long policy of ultra-low interest rates have boxed it into a policy corner when it comes to lowering rates to battle future economic downturns.   

Ben Bernanke's Best Friends and Future Employer

While I realize that this is relatively "old news", with Ben Bernanke winding up his term as head of the Federal Reserve, I thought that the subject was definitely worth a second look since his actions during the Great Emergency of 2008 - 2009 are a key part of his legacy and may well help us predict where he will end up post-Fed.

Back in 2011, the Government Accountability Office released its review of the actions taken by the Federal Reserve Board and, in particular, the Federal Reserve Bank of New York (FRBNY) during its desperate attempts to keep the world economy afloat.  Under the Federal Reserve Act of 1913, the Fed invoked its emergency authority to authorize new programs and financial assistance to individual institutions to stabilize financial markets.  Loans made under these emergency programs peaked at more than $1 trillion in late 2008.  Here is a graph showing the total outstanding loans as a function of time:

Who were the beneficiaries of this generosity?  Here is a screen capture from the GAO report that shows the aggregate dollar amounts of all loans made to each financial institution (i.e. $10 billion renewed every day for 30 days would result in an aggregate loan amount of $300 billion):

Total aggregate loans hit $16.115 trillion, more than America's total gross domestic product.  The biggest beneficiary was Citigroup coming in at $2.513 trillion, followed by Morgan Stanley at $2.041 trillion and Merrill Lynch at $1.949 trillion.  The top four American borrowers accounted for 48.7 percent of all aggregate loans made by the Federal Reserve during the crisis.  Keep that in mind when you watch banking executive compensation packages during the 2014 annual report season.

In one prime example, on March 13, 2008, the senior management at Bear Stearns notified the FRBNY that it would likely have to file for bankruptcy the following day unless the Federal Reserve Board provided an emergency loan.  The following day, the FRBNY loaned Bear Stearns $12.9 billion, a loan that was paid back on March 17, 2008 along with $4 million in interest.  This loan allowed Bear Stearns to avoid bankruptcy and continue to operate for one additional weekend while a potential suitor (JP Morgan) had a chance to look over their books.  After a further loan of $28.82 billion from the FRBNY on March 24, 2008, Bear Stearns was sold to JP Morgan for $10 per share in late May 2008.

Here is a timeline showing the alphabet soup of emergency actions taken by the Fed between December 2007 and June 2010:

On top of the emergency funding, between November 25, 2008 and March 31, 2010, the Federal Reserve purchased $1.25 trillion worth of agency mortgage-backed securities to "provide support to mortgage and housing markets and to foster improved conditions in the financial markets more generally.".

Obviously, all of this banking fun and games comes at a cost and we all know in our heart of hears that someone, somewhere got wealthy from this near tragedy.  The Fed had to enlist the help of the general banking and legal community; the lucky investment managers were paid a percentage of the portfolio value and the fortunate law firms involved were generally paid an hourly rate.  Here is a chart showing the fees paid to certain American financial companies to assist the Federal Reserve Banks in its efforts to bail out the economy:

The Fed paid a total of $659.4 million in fees for 103 contracts to various vendors for their services in helping to establish and administer the Bank's emergency programs.  PIMCO's contract accounted for $33.6 million of the total and Bank of America's lending commitment cost the Fed $21.4 million.  A whopping eight of the ten largest contracts were awarded non-competitively (i.e the Fed didn't seek other bids for the services required) due to "exigent circumstances".  You can just see the bankers rubbing their hands with glee at another's distress, can't you?  In total, 79 percent of all vendor compensation was awarded non-competitively and the largest non-competitive contract was valued at more than $108.4 million.  The largest competitive contract?  A paltry $26.6 million or 4 percent of total fees paid by the Fed.

So, now that you have all of this data in mind, would anyone care to hazard a guess at which industry Ben Bernanke will find himself employed after February 1, 2014?