And in each major economy, the challenges to central bank credibility have evolved differently. But in each case, the risks of lost central-bank credibility are suddenly more thinkable, and more visible, than they were a few months ago. In fact, the threats to central bank credibility may themselves form a new category of risk to the global economy.
BOJ – Classic currency/bond market/financial system meltdown
The credibility of the Bank of Japan seems the most immediately fragile: it is horribly easy to envisage a situation in which a run on the yen forces up interest rates (in the mild version, to head off inflation; in the alarming version, simply to underpin the currency temporarily), which in turn destroys the value of JGBs held by financial institutions.Just to put some figures on those holdings:
I) public sector debt makes up 22% of the total asset base of Japan's commercial banks, and are equivalent to just under 30% of their deposit base.
II) Public sector debt account for 48% of insurance and pension assets, and are equivalent to 61% of total insurance and pension reserves.
III) Public sector debt accounts for 79% of Bank of Japan's assets, and equivalent to 141% of the deposits made with the bank, and are 2.36x the currency issue.
More generally, with public sector debt as a percentage of GDP having sailed past 200% approximately a decade ago, any significant and sustained rise in interest rates would threaten to overwhelm almost any imaginable plan for fiscal consolidation.
So what can be said for Bank of Japan. Well first, this: that the underlying government debt situation is so extreme, and the ticking of the bond-yield bomb has been so audible for so long, that worries about the Bank of Japan's credibility have themselves developed a credibility problem. The reluctance to believe in the doomsday scenario in which Bank of Japan 'loses control of the situation' isn't simply a matter of recoiling from the horror – it is also testimony to the regularity with which the anticipation of Japan's doomsday has cost investors money.
The best chance of defusing this bomb demands: a) an economy which is growing in nominal terms but also b) inflation which is sufficiently positive to help foster nominal GDP growth, by changing ingrained deflationary expectations), but sufficiently suppressed in both absolute terms and in volatility, to keep the bond market calmly accepting of a life of modest but sustained loss of value. Tricky, very tricky.
Before the latest devaluation of the yen, however, the trajectory for inflation suggested that BOJ's attempt to rise the inflation rate to around a steady 2%, excluding tax rises, was on course.
So the question now is: what impact is the devaluation of the yen likely to have on CPI? The most obvious impact is on the price of imported fuels: overall, energy has a 7.7% weighting in Japan's national CPI, falling to 4.6% if electricity is excluded, with the largest components being gasoline (2.3%) followed by gas (1.8%). In other words, every 1 percentage point fall in the yen vs the dollar would be expected to raise the CPI by 0.05 percentage points.
Now, in September, the yen declined on average by just under 4% against the dollar, and has fallen a further 2.5% in the earl days of October. Were this to be passed through entirely to gasoline and gas prices, the combined fall would be expected to raise the CPI index by 0.3% during those two months.
But this, of course, isn't what will happen, since a) oil prices have been falling as the dollar has risen; and b) the bulk of Japan's oil contracts will not be priced in spot terms either for the commodity or for the fx rate. In both cases, in the short term this is likely to mute any inflationary impact from rising yen oil prices.
More importantly, oil remains quite a small part of the overall index weighting: the things which weigh most heavily on Japan's CPI are food (25.3%), housing (21.2%), transport (14.2%, includes oil) and culture/recreation (11.5%) - and for most of these, the pass-through from oil prices is likely to be very small.
ECB – The Discovery of Impotence
Meanwhile, over at the ECB, Mario Draghi increasingly looks like an honest man getting used to public deception. Too personal? His problem is that ever since his July 2012 willingness to to 'whatever it takes' to save the Euro, his ability to change expectations, and thus savings/investment behaviour is linked to whether he can make good on this claim. There are two major problems which would seem to restrict the scope of 'whatever it takes'. The first is simply political: German opposition to quantitative easing seems entrenched, and to have resulted last week in Mr Draghi being unwilling or unable to quantify the size of his earlier stated plans for the ECB to start buying private sector assets in the aftermath of the ECB's latest policy meeting.
The second is legal: Article 21 of the ECB's constitution forbids 'overdrafts or any other type of credit facility . . . in favour of Community institutions or bodies, central governments, regional, local or other public authorities' and bans 'the purchase directly from them by the ECB . . . of debt instruments'. On October 14th, the European Court of Justice will be hearing arguments from Germany academics on the legality of ECB's current bond-buying plans.
But does it matter just now if confidence in Mr Draghi's ability to deliver the ECB to full-blown quantitative easing gradually ebbs away? Arguably, it matters less that confidence in his promises of ECB largesse is now waning, than that it was present first in July 2012 ('whatever it takes') and again 2Q2014, since then it helped rally bond and equity markets. In the first instance, confidence in Mr Draghi's intentions helped cut the premium of 10yr BBB bonds from roughly 200bps to around 120bps; in the second, it helped push it down further, to around 95bps. More dramatically, it was part of the circumstances which allowed the premium on 10yr Spanish bonds to fall from c500bps in July 2012 to slightly more than 100bps now. Arguably, Mr Draghi's ability to buy time then was more important than the possibility that some of the currency in which he bought it may yet turn out to be lacking.
In turn, this provokes the wider question of what quantitative easing can be expected to achieve in the first place. Whilst it seems likely that quantitative easing, and indeed the prospect of quantitative easing, can and does move asset prices in a way which can be very useful to extremely-stressed financial systems, it is altogether more uncertain that it can effectively change saving/investment decisions in a way which makes a clear impact on the economy. Studies by the US Fed found that the required internal rate of return demanded of corporate investment decisions were extremely 'sticky' and so likely to be surprisingly little encouraged by falls in short-term rates or even long-term bond yields. The results of this are there for all to see: years of quantitative easing in both the US and UK have brought forth expansions which are surprising mainly for their almost complete lack of normal cyclical 'accelerators', or indeed, of any noticeably cyclical structure.
Fed – The Nostalgia for Normality
And this brings us back to the Fed, which now faces a challenge to its longer term credibility which reflects the curiously a-cyclical nature of the expansion currently underway: a nostalgia for 'normality' which seeks to re-instate a policy-making structure which simply is no longer available. Almost all commentary on the Fed's policymaking in one way or other amounts to attempts to re-interpret, re-state, or (most ambitiously) re-calculate the Taylor Rule conditions. When John Taylor first suggested the 'rule', it was simply put forward as a way of interpreting what had actually been the revealed policy of the Fed – that rate changes had been made to reflect deviations in both the actual rate from the targeted rate, and changes in the output gap (or, more loosely, how far actual output was deviating from potential output). In practice, this output gap was estimated by measuring the deviation over a long-term growth rate which had been stable enough to measure and extrapolate with confidence.
The problem is that the financial crisis has left the economics profession profoundly uncertain as to the size of the output gap, and similarly unsure as to the potential growth rate of the US. This ignorance and uncertainty was neatly illustrated by Friday's labour markets release: the 248k mom rise in non-farm payrolls suggested relatively buoyant growth, but the shocking renewed fall in the labour participation rate suggested this growth was not drawing people back into the workforce as had been expected. If that is the case, the potential supply of labour must be smaller than appreciated (and so the output gap smaller than expected). But, finally, the market doesn't seem to be tightening, since since hourly wages were unchanged on the month. As far as wages are concerned, it seems that even the mild upward pressure seen earlier in the year is abating. The paradoxes of the report point directly to the impossibility of using Taylor Rule metrics to structure monetary policy in current conditions.
In these circumstances, the credibility issue the Fed faces is twofold: the the ability to make the right decision; and the ability to persuade the rest of the world that the FOMC knows why it is making it in the absence of a credible rationale. The worry is that the 'nostalgia for the normal' will tempt them to grab for a solution which looks 'normal' – in this case, by raising interest rates – before any sort of cyclical normality is in fact re-established.
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