Is Bernanke Betting The Ranch On A US Demographic Renaissance
The BOJ pioneered QE in March 2001, with two objectives. The first was to eliminate deflation, which took hold in the mid-1990s; and the second was to shore up Japan’s fragile financial system. Did it work? Yes, for the second objective - the BOJ arguably bought time for banks tied up in NPL disposal; but, unfortunately, QE was not successful in combating deflation. The BOJ’s intended policy transmission mechanism was so-called portfolio rebalancing. Ideally, the buildup in banks’ deposits at the BOJ that earned no return (but carried zero risk) should have prompted banks to seek higher returns (with higher risk) and thus increase their lending. But portfolio rebalancing did not kick in for several reasons; most of which are the same as are occurring in the US currently. More fundamentally, however, Japan's demographics hindered any hopes of a capex-driven recovery - and policy can do little to affect that. While the US faces a less dismal demographic picture, the Japanese experience highlights that other policies (as Bernanke himself admits) are required for any sustained benefit in the real economy.
Via Goldman Sachs: Lessons From A QE Pioneer - Japan
The BOJ pioneered QE in March 2001, when it switched its policy target from interest rates - which were already effectively zero - to the balance of deposits held by financial institutions at the BOJ. The balance target was set at ¥5 tn and raised in stages to ¥30-¥35 tn. The BOJ made a commitment to keep QE in place until core inflation, which excludes only fresh food in Japan, had stabilized at levels above zero. The program concluded in March 2006.
QE had two objectives. The first was to eliminate deflation, which took hold in the mid-1990s. Deflationary pressures were rife because demand had slumped in Japan when the asset bubble - characterized by soaring asset prices and land prices in particular - that began in the mid-1980s burst in the early 1990s.
The remedies were largely entrusted to monetary policy by a government that was preoccupied with reducing fiscal deficits, which worked against the deflation fight. The second objective was to shore up Japan’s fragile financial system. Issues arising from the late 1990s financial crisis were still smoldering as banks belatedly chased up non-performing loans (NPL). The BOJ and the government were afraid of a bank collapsing before it could mend its balance sheet due to an inability to obtain sufficient funding in the money market because it was perceived as a risky counterparty. Systemic risk was a real concern.
One success, one failure
Did the BOJ’s QE work? Yes, for the second objective. The BOJ arguably bought time for banks tied up in NPL disposal, reflected in fading rate dispersion in the unsecured interbank market. When the financial crisis broke, rates began to differ widely from bank to bank due to a heavy emphasis on counterparty risk. Premiums were set according to the state of a bank’s balance sheet. But the large-scale funding the BOJ supplied under QE effectively eliminated risk premiums across the board so that even banks with serious NPL issues could get funds at low market rates.
QE calming effect
Unfortunately, QE was not successful in combating deflation. The BOJ’s intended policy transmission mechanism was so-called portfolio rebalancing. Ideally, the buildup in financial institutions’ deposits at the BOJ that earned no return (but carried zero risk) should have prompted banks to seek higher returns (with higher risk) and thus increase their lending. This should have stimulated capex and other activity that would have lifted the economy out of deflation. But portfolio rebalancing did not kick in for several reasons. Banks with heavy NPL burdens had low risk tolerance and consequently no motivation to expand their lending. Corporates cutting their debt overhang from the bubble were more interested in repaying loans than taking out new ones.
More fundamentally, however, Japan’s demographics have reduced the potential growth rate and thereby put a dampener on forward-looking economic activity such as capex. As a result, bank lending is still slack now—long after the bubble’s legacy has been dealt with—apart from special situations such as post-quake reconstruction funding demand. The potential growth rate and inflation are constrained by slowing growth in the productive population dating back to the early 1990s. Policy can do little to change a long-term, structural factor like demographics. In the meantime, low growth expectations have tended to become a mindset. In this situation, the BOJ can have little impact on deflation, no matter how extensive its fund supplies.
You can’t get around demographics
The lessons from Japan’s pioneering QE efforts are mixed. QE was only able to achieve a limited impact on real economic activity in a country that is aging rapidly, like Japan. In this sense, there should be more room for policy effects in the US and elsewhere. Japan was also not able to rely on the so-called wealth effect (where central bank action boosts equity prices, consumer sentiment, and ultimately consumption growth) because Japanese households strongly prefer to hold safe assets such as bank deposits rather than equities, unlike their counterparts in other developed economies. However, the Japanese experience highlights that other polices may be required in addition to standard QE in order to ensure that QE is having the intended effect, as policy makers across developed economies are quickly learning.
...and judging from the lagged but similar moves in US demographics... perhaps Bernanke is hoping a little too hard...
Source: Goldman Sachs and Credit Suisse