Last week was Super Wednesday for central bank watchers, as both the Federal Reserve and Bank of Japan concluded policy meetings on the same day. These events are often scheduled during the same week, but to have both decisions released within hours of each other is generally quite rare.
First let’s talk about the Fed. After weeks of going back and forth over will they or won’t they hike rates, the FOMC ultimately stood pat and did a whole lot of nothing. The range for the overnight federal funds rate was kept between 25 and 50 basis points. The official line was “the case for an increase in the federal funds rate has strengthened but [the FOMC] decided, for the time being, to wait for further evidence of continued progress toward its objectives.”
On the face of it, it is easy to argue that the Fed has achieved its objectives. The Fed (unlike most other central banks) has a dual mandate of maximum employment and stable prices. The official unemployment rate stood at 4.9% in August, which is as near as makes no difference to “full employment” as you are going to get. On the inflation front, the widely cited core Consumer Price Index (i.e. excludes volatile food and energy prices) is up 2.3% over the last 12 months, which would be above the Fed’s 2% inflation target. However, the Fed generally prefers a different inflation measure called the Personal Consumption Expenditure (PCE), and that core index is up only 1.6% over the last year.
Ultimately, the Fed’s decision likely stems from a variety of both economic, financial, and political factors. In a vacuum that only considers the U.S. economy, the Fed would have more than likely raised rates. In reality, given the global deflationary environment, the lingering unease that remains from the Brexit vote, and the upcoming political inferno that is the U.S. presidential election, the Fed took the easy way out and just did more of the same. By not acting now, that all but guarantees a hike in December unless some large unforeseen exogenous shock were to strike the economy. Initial reaction from markets was a sigh of relief and a rally higher. In the past couple days we have seen a pullback, as investors have now had time to digest the news both from home and abroad in Japan.
Hours before the Fed announcement, Governor Kuroda of the Bank of Japan released the latest effort to spur economic growth in the stagnated island nation. Depending on how you read the release, it could be construed as either a major policy shift, or a simple rehash of prior efforts.
By now investors should be well aware of the term QE, or quantitative easing, where a central bank injects cash (and liquidity) into the system through the purchase of assets such as government bonds. These purchases drive down interest rates, which in theory spurs additional borrowing and increases economic growth. Central banks around the world having been doing this since the aftermath of the 2008 financial crisis in varying amounts and styles. The Federal Reserve concluded its QE program in October 2014, but continues to reinvest interest and maturities of its current holdings
Japan on the other hand has been more creative. After years of various traditional QE programs, the BoJ instituted QQE, or Quantitative and Qualitative Easing, way back in 2013. This was designed to be a more targeted version of QE which focused buying on equity ETFs and REITs as a way of achieving the BoJ’s 2% inflation goal. Despite expanding the program in 2014 (QQE2), inflation in japan remains muted with the headline number coming in at -0.4% year-over-year (i.e. deflation) and the core number at a modest 0.3%.
All of this set the stage for the announcement last week. Basically what it boils down to is that the BoJ pulled from Mario Draghi’s book at the European Central Bank and dropped a “whatever it takes” statement. Instead of continuing the targeted QQE2 asset purchases at a specified rate, the BoJ is going to vary the amount of purchases and commit to not only meeting its inflation target, but to overshooting it at least temporarily. The announcement also included a new tool dubbed “yield curve control”, which is a fancy way of saying that the BoJ plans to peg the Japanese 10 year yield at 0%. Compare that to the U.S. and the yield on the 10 year Treasury looks absolutely juicy at 1.6%. The idea is that “yield curve control” will help banks, as the front end of the curve is in negative territory and banks like a steeper curve. Whether or not this will work remains to be seen, but it does hurt elderly household savers who maintain the equivalent of roughly nine trillion US dollars in cash deposits and are earning zero.
In the world of monetary policy we are definitely in uncharted territory. Much is starting to be said about the limits of what central banks can and should do. Sustainable reforms are needed throughout the world on the fiscal and legislative side of things. The marginal returns from central bank actions seem to be diminishing as they continue to do more and more of the same, and the results are becoming less effective. This week our local investment management society will be welcoming an expert on the Japanese economy to speak about recent economic developments and the options left for the BoJ. We look forward to hearing his insights and will report back on this in a future blog post.
Nicholas Case, CFA®
Senior Investment Analyst