Rising interest rates and time inconsistency problems
On the 26th of May, BoJ governor Kuroda addressed a seminar of academics, and touched on the issue regarding JGB price fluctuations, resultant valuation losses for Japanese banks and possible financial system instability that we examined here: https://nipponmarketblog.wordpress.com/2013/05/28/japanese-banks-tier-1-capital-and-financial-system-stability/
The issue at hand is the extent to which a fall in JGB’s (as a result of an asset allocation switch from JGBs into equities as well as the longer term draw-down of pensions schemes as the population ages), will impact the value of the holdings of JGBs at Japanese banks, thus damaging their Tier 1 capital ratios.
In his remarks, Mr Kuroda said estimates by the BOJ in April showed a rise in interest rates by around 1% to 3% would not cause major concerns over Japan’s financial system, as long as the rise is accompanied by improvements in the economy. That is because the economic recovery would lead to increased lending and help improve banks’ earnings, he said.
Well, that is a fairly obvious point to make, and we have no doubt that when examining its econometric models the BoJ does indeed find that higher rates are almost invariably accompanied by higher economic growth. However, there are two problems with this:
1. The causality is crucial. Higher rates do not lead to higher growth. In fact the opposite is most often true, but we have to assume that the BoJ is well aware of this. However, this statement does seem to reflect a kind of ‘blue-sky’ thinking within the BoJ, where perhaps due attention might not be paid to outcomes that are not desireable.
2. There is a very obvious ‘time inconsistency’ issue at play here. If higher rates are the result of higher inflation expectations and/or doubts about the sustainability of public finances and/or BoJ monetary policy, then rates will jump well before any Abenomics induced economic growth appears. In this scenario, things obviously look a lot less rosy for the banks’ balance sheets and capital ratios.
NipponMarketBlog wonders what the BoJ estimates for bank balance sheets and for wider financial system stability look like if rates climb between 1% and 3%, without any significant, healthy and organic economic growth that will also result in increased bank lending and thus revenue. Mr Kuroda, though, seems confident:
“Japan’s financial system as a whole seems to possess sufficient resilience against such shocks as a rise in interest rates and deterioration in economic conditions.”
In addition to the financial stability issues, the BoJ must also attempt to make sure that no asset bubbles start to emerge. Mr Kuroda has let it be known that the BOJ will take “appropriate action” if financial imbalances emerge, suggesting that the BOJ will ease off on QE if it causes an “unwelcome asset price bubble”. However, as Kuroda puts it:
“There is no sign at this point of excessively bullish expectations in asset markets or in the activities of financial institutions.”
Finally, Mr Kuroda made an interesting comment which is illuminating vis-a-vis the inter-play between the Japanese government and the BoJ:
“The BOJ made a clear commitment to achieve its price target. I’d like to call on the government to map out a clear plan to restore Japan’s fiscal health and a growth strategy – and most importantly, ask that they be implemented.”
This seems to NipponMarketBlog to be a sort of ‘pre-emptive passing of the buck’, just in case things do not go according to plan and rates eventually spike much higher before any significant and sustained growth materializes in the Japanese economy. Clearly, the somewhat uneasy relationship between the government and the BoJ that seems to have materialised since the QE announcement on the 4th of April 2013 and the resultant jump in JBG market volatility is continuing, as we also expanded on here: https://nipponmarketblog.wordpress.com/2013/05/19/too-much-of-a-good-thing/
We should make it clear that we do not foresee a significant risk of financial system instability in the absence of a collapse of the JGB market, but we are concerned that the BoJ is to some extent ‘winging it’, and the BoJ policy committee minutes seem to confirm that impression. For example, the minutes from the April 26th BoJ policy commitee meeting showed some commitee members opposed to targeting a 2% inflation rate in just two years, arguing for a more flexible approach in term of timing.
NipponMarketBlog fears that the reality of this situation is that the BoJ is nowhere near as much in control as the are attempting to appear. The risk is that the market sees through this, and ends up calling the bluff. In the context of the global QE bonanza that has materialised over the past decade (and which Japan is now joining whole-heartedly), NipponMarketBlog repeatedly finds itself drawn to the image of the worlds central bankers sitting around the roulette table, betting everything on the one chip they have – QE.
Gentlemen! Welcome to the Quantitative Casino. Please place your bets!
Mr Kuroda – all in on red….