If anyone is an expert on the unintended effects of quantitative easing, it’s the Bank of Japan.
In fact, one might say, what the Fed, ECB, BoE are facing today, the BoJ has already faced. What’s more, what the BoJ is facing today, the Fed, ECB, BoE will face too.
Which is why — in the context of the BoJ’s Valentine QE extension and Mervyn King’s semi existential crisis on Wednesday, in which he continuously pointed out that there are limits to monetary policy — it’s worth rehashing some quick BoJ QE background.
First off, BoJ governor Masaaki Shirakawa has long stressed that fundamental realities, like an ageing population, can’t help but impede the effectiveness of Japanese monetary policy. More so, that breaking the economic malaise lies just as much in fundamental adjustments to the real economy as it does in central bank action. In other words, there is only so much a central bank can do. Eventually real adjustments have to be made.
If not, at some point balance sheet expansion might actually begin to achieve diminishing returns. (Though Mervyn himself doesn’t think we’re quite there yet in the UK.)
Nevertheless, if there was to be an unintended impact anywhere, then — based on the Japanese experience at least — it was always most likely to manifest in money markets and/or savings rates. An unintended consequence which, incidentally, first became fully realised from about 2005 onwards.
Note the following observation from a 2005 BoJ working paper about the country’s open market operations under quantitative easing policy, which talks about the changing use of current account balances (CABs) by banks — beyond the mere scope of achieving reserve requirements. It mentions the role they played in establishing the so-called yen carry trade (via the FX-swap market, where yen becomes collateral for dollar loans):
(1) Counterparties regard the Bank’s operations as financial transactions for a wide variety of purposes rather than a means merely for accumulating their CABs for immediate reserve requirements and settlement needs. Securing future liquidity and obtaining profits are major motives for bidding operations. As a consequence of bidding, counterparties come to hold excess reserves whose opportunity cost is almost zero. Financial system instability and malfunctioning of the money markets have been important factors behind the demand for operations, the latter of which may have been induced, to some extent, by QEP itself.
(2) To stimulate counterparties’ demand for operations, the Bank has taken various measures. One of the effective measures has been to increase outright purchases of long-term JGBs. The Bank has set an upper limit on the purchase amount in order to secure future flexibility in market operations and to indicate that the purpose of its operations is not to finance government expenditures. The Bank has also modified other operational tools, such as extending the maturity for short-term operations.
(3) In addition to the modification of operational tools, the Bank’s Operations Desk has made daily efforts more than ever for successful bidding, in terms of detecting subtle changes in financial market transactions and utilizing various types of operational tools. Such daily efforts have been necessary since large fluctuations of autonomous factors have occasionally forced the Bank to accumulate larger outstanding amounts of funds-supplying operations over a short period of time in an environment where even term instruments bear zero interest rates.
(4) Yen selling intervention in the foreign exchange market cannot be considered a factor in achieving higher target levels of CABs, since the series of transactions related to yen selling interventions has a neutral effect by nature on CABs and the Bank’s operations.
All very deja vu, especially when you consider the current steps being taken by the Fed, the ECB and the BoE as well as the money market malfunctions experienced in those respective markets.
Which brings us to the next step in the Japanese experience, one which echoes very clearly fears recently expressed by Bill Gross of Pimco. Our emphasis:
This has led to the accumulation of domestic banks’ CABs and thereby increased the sense of excess liquidity in the market. Such a perceived excess liquidity has contributed to the decline in rates on FBs and TBs to almost zero. This has exacerbated the sliding amount of bidding in operations based on the “second motive,” which is to secure profits. In these circumstances, the Operations Desk has taken several measures such as the extension of the maturity in the daily conduct of operations to achieve the target. The longest maturity for outright purchases of bills reached to eleven months in March.
Although the target has been achieved with the effects of these measures, the level of CABs has occasionally decreased close to the lower bound of the target due to repeated unsuccessful auctions in funds-supplying operations. In prospecting future developments of market operations, one of the important changes recently observed is that some banks seem to be becoming reluctant to hold a large amount of excess reserves due to awareness of the expansion of their balance sheet and the low return on assets (ROA). ROA tends to decline as financial institutions hold a larger amount of CABs bearing no interest rate. Although the opportunity cost in terms of interest rates is still close to zero, some banks recently seem to have begun regarding low ROA as a cost of holding excess reserves as they focus more on profitability of their assets.
In other words, the incentive to hold excess reserves (needed to support the Japanese economy) diminishes as yields drop or go negative. In the Japanese case, the “low return on assets” became a problem in its own right. See the echo?
Understandably, those low returns weren’t just a problem for Japanese banks alone. Any institution which was strategically obliged to hold liquid Japanese assets began suffering and was as a result forced “up the curve” or into complete alternatives.
The following snippet from the Fed’s 2005 records provides some interesting colour regarding the problem (our emphasis):
MR. KOS. The second item is the Authorization for Domestic Open Market Operations, which I propose be approved with one amendment as described in the memo dated January 24, 2005. That amendment would eliminate the so-called leeway provisions—the limit on the amount by which holdings of securities in the System Open Market Account can change between meetings—given that the Committee has many other ways to oversee the activities of SOMA [System Open Market Account].
In short, the Japanese money market has become very difficult for investors and, in fact, for the BOJ. Why do I go on at length about this? Well, for two reasons. First, Japan offers a genuine case study of monetary operations at the zero bound, which is interesting in and of itself. Second, we are directly affected by this deterioration of liquidity in the money market since the U.S. monetary authorities are a very large investor in Japanese government treasury bills. Like others, we have had difficulty investing all the yen in accordance with the current investment guidelines. Given these circumstances, unless conditions improve very soon, we essentially will have two choices: (1) to expand the range of allowable instruments for investment beyond sovereign obligations, or (2) to go out the JGB [Japanese government bond] curve. I plan to return to the Committee in March with a report on my plans to deal with this situation.
Yen-denominated liquidity was, in a nutshell, being forced into ever longer durational saving structures or “lock ups” to achieve any yield at all — a fact which not only encouraged alternative investment strategies, but most notoriously perhaps the FX punting habits of Mrs Watanabe herself.
That these trends are being repeated in western economies more than explains the current rush into emerging market or commodity crosses and assets — inevitably draining liquidity from low-yielding domestic markets as they do (thus creating a need for more QE or alternative central bank tactics like Operation Twist).
In another sense, central banks are being incentivised to coerce solvent investors/institutions to lend or place cash domestically by flooding the market with so much liquidity for guaranteed durations so that the risk evaporates completely. But by doing so they are depressing yields, only encouraging capital flight (Mrs Watanabe style) while creating a “low return on (safe) assets” vicious circle.
Only when emerging market/commodity/periphery risks begin to match the risks associated with “non-safe” domestic assets, might central banks arguably succeed in transferring liquidity to where it is really needed.
While the mismatch remains, however, liquidity operations and QE in particular — as Mervyn King rightly pointed out -- act more as a subsidy to investors who are not prepared to take any risk domestically without it.
The question is, what happens when emerging market/periphery and commodity risk begins to outweigh the prospect of better returns before appetite to lend or invest domestically returns? In other words, when the Mrs Jones of this world decide that the yields on EM or commodity exposure are not worth it given the risks.
Where does the liquidity go then? Gold? The last remaining safe bonds? That which is considered least risky with the highest yield? Or tangible assets like real estate? Or even equities?
In other words, might we come full circle? Or will things just get a helluva lot more volatile and flighty instead?
Related links:
German negative yields as harbinger of deflation - FT Alphaville
Collateral shifts in the eurozone – FT Alphaville
The Gross paranormal, a.k.a the time depreciation of money – FT Alphaville