A central bank litmus test for 2013

It's unlikely the era of unlimited quantitative easing will falter in the year ahead. But Japan will be a global test case on whether this approach has run out of ammunition.


Many year-end reviews of market behaviour in 2012 have rightly argued that the role of the central banks has once again proven critical, trumping all other factors, including the state of the global economic cycle. In fact, two brief statements by ECB President Mario Draghi have been the decisive events in the global financial system this year.

The first, which actually took place in the early hours of a eurozone summit on 9 December 2011, was Draghi’s favourable assessment of the latest political moves towards fiscal union. This unleashed the ECB’s Long Term Refinancing Operations in the first half of the year. The second, on 26 July 2012, came when Draghi said that the ECB would do "whatever it takes” to keep the single currency intact. This led to the launching of the Outright Monetary Transactions program in September. Although still unused, the mere possibility of unlimited ECB bond buying in Spain and Italy via the OMT was enough to produce a powerful rally in global risk appetite, despite mounting concerns about the US fiscal cliff. .

Understanding the developing attitude of the central banks, and the effects of their actions, obviously remains central for investors in all financial assets. The "big picture” for global financial assets, involving very low government bond yields and a gradual shift of risk appetite into credit and equities, is unlikely to change until one of two events takes place.

The first would be a decision by the central bankers themselves that the era of unlimited quantitative easing must end, either because of the risk of inflation and asset price bubbles, or because of concerns about fiscal dominance over the monetary authorities. The second would be a realisation by the markets that further action by the central bankers is irrelevant because they have run out of effective ammunition. Either of these events would probably remove the central prop from the equity bull market which began in March, 2009, but neither seems very likely in 2013.

There is certainly no sign that the central bankers themselves will call a halt to the extension of their balance sheets. The Fed, for example, has just embarked on QE3, an unlimited combination of quantitative and credit easing, despite the fact that Bernanke himself has expressed concerns that the growth of potential GDP might recently have slowed sharply. Instead of concluding that this might lead to inflation risks, implying that monetary policy should be tightened earlier than previously expected, the Fed chairman seems to have concluded that it is in fact a reason for easing policy even more aggressively.

His reasoning seems to be that the supply potential of the economy is in danger of becoming dependent on, or "endogenous to”, the weakness of domestic demand. This belief in the "endogeneity of supply” (horrible term, I know), under which potential output automatically adjusts upwards and downwards to a level of GDP ultimately constrained by aggregate demand, is something we are likely to hear much more about in 2013. In the US, the main factor leading to the endogeneity of supply is the drop in the labour force participation rate, while in the UK it is the weakness in labour productivity.

Central bankers are inclined to assume that these forces can be reversed if demand grows more rapidly, thus increasing supply potential in line with demand. On balance, they are probably justified in assuming this, but the danger is that inflationary pressures will rise without the central bankers realising it. That is a risk they remain very willing to take.

What about the second risk, that the markets will spontaneously decide that the central banks have run out of effective ammunition? The test case for this hypothesis seems likely to be Japan.


After many years in which the Bank of Japan has increased its balance sheet almost exclusively by purchasing government debt of two or three years’ duration, many investors had concluded that this form of QE was largely irrelevant. This is not surprising, since it involves swapping one very similar asset (short dated JGBs) for another (reserve balances at the Bank of Japan) in bank balance sheets.

It is hard to conceive of a less effective version of QE than that. Nevertheless, Japanese equities and the yen have reacted significantly to the recent arrival of the Abe government, which will force the Bank of Japan to adopt a 2 per cent inflation target in January. Since the mere announcement of a target, without the effective means to enforce it, is unlikely to impress the markets for very long, the key question for 2013 will be whether the bank, under its new leadership, is willing to adopt entirely different measures to boost nominal demand.

These measures would presumably have to include purchases of assets other than short dated JGBs to try to boost equities and credit, while reducing the value of the yen. Several different options appear to be under discussion. For example, the Abe government is considering a new fund designed to reduce the value of the yen, under the joint administration of the Ministry of Finance, the BoJ, and the private sector. If this fund leads to a wider diversification of pension fund and insurance company assets into overseas markets, it could have a profound effect on the exchange rate and the future of the economy.

In any event, the markets’ benign response to the arrival of a Japanese government which is pledged to force the Bank of Japan to change its strategy, is very telling. In a different economic environment, this clear demonstration of fiscal dominance over the monetary authorities could easily have resulted in a bond market and currency crisis, but none of this has occurred. Instead, bond yields have moved sideways while equity prices have risen by over 20 per cent. Clearly, the demonstration in Japan that an era of more serious financial repression has arrived has not caused any great alarm in the markets.

One day, the markets may start to react in a much more malevolent way to the prospect of yet more financial repression via endless quantitative easing from the central banks. But that day does not seem to have arrived, and probably will not do so in 2013.

Copyright the Financial Times 2012.

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