February 8, 2018

Japan’s long experience with zero interest rates shows there is no quick exit

William Pesek

After surviving the biggest shock on Wall Street in years, many global investors have their eyes firmly on new Federal Reserve Chairman Jerome Powell for guidance and comfort. They may find more of both at the Bank of Japan.

Much of the panic reflects fear that central bank liquidity — the fuel behind the long global equities rally — will disappear faster than previously thought. A 2.9% jump in January in U.S. hourly earnings has punters betting Powell will fear resurgent inflation and accelerate the tightening cycle that predecessor Janet Yellen started in late 2015.

Not so fast, if Japan is any guide. To understand why the Fed may be less hawkish, let us go back to 2001, when then-Gov. Masaru Hayami pioneered quantitative easing. By the time Hayami’s successor, Toshihiko Fukui, inherited the experiment in 2003 — and an improving economy — monetary purists began arguing for monetary normalization.

Three years on, Fukui felt he had a strong case. The economy had expanded at a 3.1% pace in January-March, a fifth consecutive quarter of growth. Seven years of deflation gave way to consumer prices rising for seven straight months. The BOJ’s July 14, 2006 hike to 0.25% from zero landed with a thud. The yen, oddly, lost value against the dollar, while investors and politicians howled. That day, an unhappy finance minister, Sadakazu Tanigaki, said: “There is no change in my view that the BOJ should help the economy achieve a sustainable recovery on the monetary policy front.”

Fukui’s BOJ stood its ground, even as the Nikkei Stock Average mostly fell over the next 222 days until its second step — a further 25 basis points to 0.5% on Feb. 21, 2007 — sent the yen and Nikkei even lower. Shinzo Abe, in his first stint as prime minister, warned the BOJ to consider the consequences of its actions. Business lobbies and politicians, meanwhile, increased their criticism of a renegade central bank.

By 2008, the BOJ relented. The first act by Fukui’s successor, Masaaki Shirakawa, was returning rates to zero. In 2013, when today’s BOJ chief Haruhiko Kuroda came along, Tokyo pressed even deeper into the monetary unknown — far beyond anything Hayami dared try in 2001, or Ben Bernanke, the then-Fed chairman who in 2009 took the U.S. down the QE rabbit hole.

Why does all this matter to today’s panicky investors? If Japan has proved anything in these last 17 years, it is that rate hikes globally will be slower than investors think. The fact is, nations that lower rates to zero tend to get trapped there.

Intellectually, economists and politicians alike complain about the evils of free money and the moral hazards that follow. But arguments against currency debasement and corporate welfare quickly go silent when the tide starts going out. Only then do politicians, bankers, executives and investors alike realize just how reliant on monetary largesse their successes and bottom lines have become.

Zero rates and free money make governments carrying crushing debt loads feel more solvent. The deeper central bankers push their tentacles into bond markets, the more credit spreads take continued monetary largesse for granted. Stocks, too, become addicted to the steady flow of central-bank steroids lifting asset prices. Why has not the Kuroda BOJ been able to “taper” debt purchases, never mind raise borrowing costs? It is caught between a complacent government slow-walking pro-growth reforms, financial and business sectors hooked on free cash and markets looking for any excuse to drive the yen higher.

The U.S. finds itself in a comparable position. Granted, Washington’s QE experience is not Tokyo’s. Relative to Japan, which dragged its feet of ridding banks of bad loans, Wall Street’s post-Lehman crisis purge moved at lightning speed. The Fed put 125 basis points of distance between its benchmark and zero. The BOJ, none this time around. Nor has Japan produced a wage spike equivalent to America’s in January.

At the same time, the U.S. boasts so much of what stagnant, change-averse Japan does not: a growing and markedly younger population; a vibrant startup scene; a high appetite for economic disruption; incentives and mechanisms for brutal corporate restructuring; few barriers to acquisitions from overseas; and relatively healthy productivity. What they share in common, though, is political paralysis that puts on the onus for supporting growth on monetary policymakers, and in unhealthy ways.

The negative feedback loop is a powerful one. If you think Japan Inc. reacted furiously to the BOJ, imagine the hell storm the Powell Fed will face if President Donald Trump deems it insubordinate. Almost daily, Trump touts the surging Dow Jones Industrial Average as a personal triumph, as if it absolves all manner of scandals and sins. The @realDonaldTrump Twitter feed is sure to blame the Fed early and often for killing Wall Street’s boom and deadening the effects of his Republican Party’s recent tax cut.

In fact, the ferociousness of the recent selloff alone may cow the Powell Fed, just as it did the Fukui BOJ a decade ago — and likely Kuroda’s today. Expect Trump loyalists on Capitol Hill to hold congressional hearings and investigate how the central bank is stopping Trump from making America great again.

The Fed, many will counter, is independent. That cannot happen, right? Is it really a stretch to think a president who throws the Federal Bureau of Investigation, the Justice Department and lawmakers who do not clap for him under a metaphorical bus to save his hide will not demonize the central bank?

In any case, the American financial system is not ready for the more assertive tightening moves that recent data convinced investors are coming. The frenzied selling of the last few days is proof enough of that that some of the trauma of 2008 remains. Bottom line, tightening by the Fed, BOJ and European Central Bank will be less draconian than in the pre-Lehman shock world.

For sure, leaving the proverbial punchbowl out indefinitely comes with risks. Cheap money might only increase the level of collective addiction and reward bad behavior like excessive leverage. Nor are investors selling shares without justification. Markets have skyrocketed in recent months on seemingly little more than momentum. That is partly why Japan is bearing the brunt of Asian declines. Even though nearly 70% of Nikkei-listed companies beat estimates this reporting season, investors see shares as racing ahead of economic reform and corporate governance upgrades.

But just as Tokyo papered over its cracks with BOJ cash, U.S. lawmakers and policymakers abdicated their responsibilities to revive growth to the Fed’s ATM. That explains why long-inebriated asset classes are experiencing sudden, and debilitating, withdrawal pains. It also explains why those fearing the Fed is about to slam the brake with both feet can relax. For now, at least.

William Pesek is a Tokyo-based journalist and author of “Japanization: What the World Can Learn from Japan’s Lost Decades.” He has written for Bloomberg and Barron’s.

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