BNP Warns On Japanese Repression: Echoes Of The 1940s Fed
In the 1940s, the Fed adopted pegging operations to protect the financial system against rising interest rates and to ensure the smooth financing of the war effort. In effect, the Fed became part of the Treasury’s debt management team; as the budget deficit hit 25% of GDP in WW2, it capped 1Y notes at 87.5bps and 30Y bonds at 2.5%. From the massive bond holdings of its domestic banks to its exploding public debt, Japan today faces a situation very similar to the US in the 1940s. With the market becoming dysfunctional as the BoJ’s massive buying operations drain the pool of available bonds, the BoJ’s overriding presence in the market each day has increasingly made the JGB market seem like a government-made market.
But a much bigger problem is Japan’s exploding public debt. With the debt already the largest of the developed nations, it could snowball out of control if an upturn in interest rates causes interest payments to escalate. So, even if 2% inflation is achieved, the BoJ’s zero-rate policy and massive JGB purchases will have to continue until the debt is made more manageable.
When the long-term rate climbs above 2%, the BoJ will probably adopt outright measures to underpin JGB prices to prevent turmoil in the financial system and a fiscal crisis - and just as Kyle Bass noted yesterday, they are going to need a bigger boat as direct financial repression in Japan is unavoidable.
With the market becoming dysfunctional as the BoJ’s massive buying operations drain the pool of available bonds, the BoJ’s overriding presence in the market each day has increasingly made the JGB market seem like a government-made market. Those well versed in history may recall that the Fed’s policies in the 1940s to stabilise prices and yields on US government securities – the so-called pegging operations – also resulted in a government-made market. The Fed at the time was deeply entangled in the government’s debt management, so, despite the upturn in inflation, it had to keep long-term rates very low and continue to buy massive amounts of government securities as part of financial repression.
The Fed started down the road towards pegging operations when it intervened in the bond market in the spring of 1935 to prevent rising interest rates from degrading the capital of US banks (more than 50% of assets had to be “safe” government securities) and thereby destabilising the financial system. With the start of WWII, the Fed’s government bond buying morphed into outright support of bond prices (pegging operations), as the shift to a wartime footing necessitated low-cost financing of the war effort. Even when inflation picked up, the policies supporting government bond prices were not allowed to end, causing the Fed to come into repeated conflict with the Treasury Department over policy independence.
Ultimately, the Fed’s bond price-supporting policies enabled banks to reduce their long-term bond holdings substantially, reducing the impact of rising interest rates on the financial system. And after roughly 10 years, the Fed was finally freed from the constraints of this support programme because (a) banks came to favour ending the programme, as they were now in a position to enjoy the merits of widening margins of a steepening yield curve, (b) the US economy and fiscal conditions returned to normal, as public debt was significantly reduced thanks to improved tax receipts from the expanding economy and the “inflation tax” and (c) subsiding concerns about higher interest rates threatening the financial system and state finances allowed inflation to be perceived as the main problem for the economy and society. While the pegging operations may have been inevitable owing to special factors like WWII, the result was the sacrifice of price stability and the destabilisation of the US economy.
Japan’s situation today, from the massive bond holdings of its domestic financial institutions to its exploding public debt, has many similarities to the US of the 1940s. Of course, BoJ Governor Haruhiko Kuroda is adamant that the BoJ’s quantitative and qualitative monetary easing is meant only to defeat deflation and should not be construed as bankrolling the government’s spending. At this juncture, there is no clear line separating JGB buying to fight deflation from JGB buying to underpin debt management. But we think that once 2% inflation is attained and the BoJ finds itself prevented from seeking a way out, it will be clear that the BoJ has, indeed, embarked on monetisation.
The BoJ will first be confronted with concerns about financial system stability. If we assume that the equilibrium real interest rate is 1%, the realisation of 2% inflation will necessitate raising the long-term rate above 3%. But a long-term rate of just 3% could put financial institutions for small businesses, with their huge JGB holdings, at increased risk of insolvency, something that could induce turmoil in the financial system. At 4%, even regional banks could be in trouble. So, even after 2% inflation is achieved, concerns about damage to the financial system could force the BoJ to maintain its zero-rate policy and massive JGB buying.
In the US in the 1940s, with the Fed’s aggressive purchases, financial institutions greatly reduced the durations of their bond portfolios and were more resilient to rising interest rates.
The actions by the BoJ may work the same magic here. According to our estimates, if the BoJ continues to buy long-term JGBs at the current pace, at the end of 2014, it will hold roughly 40% of the entire 2- to 10-year market – the core assets of regional banks – compared with just 10% at the end of March 2013. Banks’ portfolio durations will be significantly reduced, making them more resilient to rising interest rates. This should alleviate fears of a financial crisis somewhat.
But a much bigger problem is Japan’s exploding public debt. With the debt already the largest of the developed nations, it could snowball out of control if an upturn in interest rates causes interest payments to escalate. So, even if 2% inflation is achieved, the BoJ’s zero-rate policy and massive JGB purchases will have to continue until the debt is made more manageable. This means that the BoJ’s balance sheet won’t be determined by price stability. As Thomas Sargent and Neil Wallace noted in Some Unpleasant Monetarist Arithmetic (Federal Reserve Bank of Minneapolis, Quarterly Review, autumn 1981), the BoJ will face being fiscally dominant.
Currently, with volatility continuing in the JGB market, if the upturn in the long-term rate persists, the BoJ will probably have to enlarge the scale of its annual purchases at a later stage. Then, when the long-term rate climbs above 2%, the BoJ is likely to adopt outright measures to underpin JGB prices so as to stave off turmoil in the financial system and a fiscal crisis. For example, like the Fed in the 1940s, the BoJ may fix the 3m and 1y rates, thereby effectively setting ceilings on the 5y and 10y rates. While this could ensure financial institutions earn carry, this would be nothing other than the start of financial repression.
The US was able to liquidate the massive debts built up from the Great Depression and wars thanks to robust post-war growth, coupled with the negative real interest rate engendered by financial repression. Today, however, as we cannot expect economic growth to be as robust as it was then, we may have no choice but to adopt financial repression, so that our public debts can be liquidated via an inflation tax on depositors. Considering Japan’s huge public debt, it seems inevitable that even after the inflation target is achieved, the zero-rate policy and massive JGB purchases will have to continue for a long time as part of financial repression.