Japan rings the bell on a deflation death match

Japan’s staggering stimulus is part of a worldwide trend, with little doubt the ECB’s policy will also be looser before long. But Tokyo’s efforts could run into intrinsic design flaws.

Some of the worst performing economies in the world – the eurozone, the United Kingdom and Japan – had central bank meetings in the last 24 hours. All three central banks kept monetary policy settings firmly positioned at super stimulatory levels as they struggle to kick-start a decent pace of economic growth and reflate their depressed economies.

The stunning highlight was the move from the revamped Bank of Japan under new Governor Haruhiko Kuroda. The BoJ delivered a quite staggering monetary policy easing that is designed to lift inflation to 2 per cent within two years. In order to reach this goal, the BoJ re-wrote the template for central banking by changing the policy instrument from the overnight interest rate to the monetary base.

Specifically, the BoJ will increase the monetary base by between ¥60 trillion to ¥70 trillion per year (around $610 to $710 billion Australian dollars) to push inflation higher towards the new target. The BoJ will extend the bond buying program across the yield curve out to 40 years.

In effect, this easing of monetary policy puts in place the policy promises outlined by Prime Minister Shinzo Abe, who earlier this week reiterated his objective of kick-starting nominal GDP growth.

A number of market players have expressed cautious hope that this stimulus will work but note a number of key problems. The economists at ANZ Bank note that only twice in the last 20 years has Japan seen the inflation rate hit 2 per cent and on both of those occasions it was driven by temporary one-off influences – a rise in the level of the consumption tax and a spike in oil prices. It has been over two decades since Japan had 2 per cent inflation that was driven by underlying demand conditions.

ANZ also points out that growth in the money supply is poorly correlated with inflation to the point where it is sceptical about “the ability of such a strategy in itself to achieve inflation”.

The impact of the policy announcement was immediate and powerful. The yield on 10-year Japanese government bonds fell to a staggering, new record low of 0.425 per cent at one stage, while the 30-year bond yield dropped to 1.31 per cent. At the same time, the yen fell over 3 per cent against the US dollar to be trading around 96.20 this morning.

In the eurozone the ECB left interest rates unchanged at 0.75 per cent, but it stands ready to cut interest rates if the economy deteriorates further. The ECB’s policy intransigence was again disappointing, particularly given the assessment of the economy from President Mario Draghi who said that “weak activity has extended into the early part of the year and a gradual recovery is projected for the second half of this year, subject to downside risks.”

A reasonable observer would suggest that lower interest rates now would help head off those “downside risks”, particularly with the ECB’s internal forecasts showing inflation will fall to 1.3 per cent in 2014 from 1.6 per cent in 2013 to be locked in significantly below its 2 per cent target.

That said, Draghi also indicated that if the eurozone economy weakened, the bank “stand[s] ready to act” and that it is “considering both standard and non-standard measures” to stimulate the economy.

There seems little doubt that it is only a matter of time before the ECB will in fact cut interest rates and deliver some form of quantitative easing, given the lacklustre growth outlook.

In the UK, the BoE kept rates at 0.5 per cent and maintained its asset purchases at GBP375 billion. There was no commentary associated with the BoE decision, but that absence of further stimulus was enough to see a small rise in the British pound. The minutes of the meeting will be released on April 17.

This mix of news showing that monetary policy is easy and likely to get even easier follows the Reserve Bank’s meeting on Tuesday, where it left official interest rates unchanged but demonstrated a clear easing bias.

While the global economy is in better shape now that it was six or so months ago, there are clearly bumps and twists ahead. For Australia, there is still the problem of an over-valued currency, which remains at a 28-year high of 79.3 points on the trade weighted index. Given the recent news on retail spending and housing that shows a strong lift in activity, the Reserve Bank is likely to sit tight on policy for many months to come.

For the central banks that have made policy decisions in the last 24 hours, it remains the case that things are fragile. In the largest economic region of the world (the eurozone), the fourth largest economy in the world (Japan) and the seventh largest country (the UK), monetary policy is incredibly stimulatory. And it needs to be, given the poor economic performance in all of them and the risks that an economic upswing is still not guaranteed.

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