Raising Very Low Central Bank Rates Easier Said Than Done
July 15, 2010
Having followed Bank of Japan policymaking since before Japan’s financial crisis, I was suspicious when consensus forecasts surfaced several months ago that the Fed funds rate would rise later this year. I’m even doubtful about 2011. A U.S. recovery had begun after mid-2009, and GDP growth accelerated to a 5.6% annualized pace in 4Q09 and an on-year advance of 2.4% by the first quarter of this year. Moreover, some officials on the FOMC were chomping at the bit to get on with rate normalization, even as the committee majority retained a conditional prediction of no change for an extended period.
The FOMC statement of June 23 not only kept that forecast but conceded that “underlying inflation has trended lower.” Minutes released yesterday from that meeting go farther in revealing a retreat in FOMC optimism, expressing that about half of the Fed’s committee members believe growth risks are skewed to the downside and explicitly noting that “a few participants cited some risk of deflation.”
On cue, several weaker-than-projected economic indicators were released this morning:
- Factory output fell 0.4% in June after strong advance in April and May.
- The New York Fed manufacturing index tumbled 14.5 points to 5.1 instead of losing about a point as analysts assumed.
- The Philly Fed factory index dropped three points instead of rising two points.
- Producer prices fell 0.5% after dropping 0.1% in April and 0.3% in May. On-year PPI inflation has been more than halved from 6.0% in March to 2.8% as of June. Core PPI is now just 1.3%.
A number of eery parallels exist between Japan after 1990 and the United States after 2006. In each economy, bursting asset bubbles set off a chain reaction of mounting distress in the balance sheets of financial institutions and recession in their economies. The fiscal response in both countries was a sharply higher deficit, administered in part by design and partly via diminishing tax revenues. Japan approved extra fiscal injections of JPY 11.3 trillion in March 1992, JPY 10.7 trillion in August 1992, JPY 13.2 trillion in April 1993, JPY 6.2 trillion in September 1993 and JPY 15.3 trillion in February 1994.
Interest rates were reduced. Japan’s overnight money rate target had been above 8.0% in early 1991, while the Fed funds rate was at 5.25% from mid-2006 until mid-September 2007. The Bank of Japan had not reacted immediately to the financial crisis, fearing inflation. Fed officials made sure they did not make the same mistake, and while that probably shortened and mitigated the depth of the U.S. recession, having been prepared may not matter in the long run. After slashing its interest rate to a range of zero to 0.25% by March 2009, the Fed ramped up its stimulus additionally by engaging in quantitative easing, which now has been stopped.
Might the U.S. crisis is that it might continue to mirror Japan’s experience? After a period of more than a year with near zero interest rates, the U.S. might have a difficult time handling any kind of rise in rates or tightening of fiscal policy. First, let’s review what transpired in Japan. By September 1995, the overnight money rate target had dropped all the way to 0.5%. Officials in a five-year projection still assumed real economic growth would average 3% per annum through 2000, low by historical standards at that time but way better than what in fact occurred. Over the ten years between 1Q90 and 1Q00, real GDP grew just 1.5% per annum, and sustained on-year declines in the GDP deflator developed by 1996. The scope for lowering interest rates had been exhausted, and monetary officials were in fact constantly searching for an opportunity to raise rates instead. An ill-advised national sales tax of two percentage points in 1997 just before the Asian crisis caused a huge setback for the economy, but unconventional monetary measures were not considered as a counter-weight then. Faced with more malaise, officials relented and cut their money rate target in February 1999.
The Bank of Japan’s philosophical bias remained skewed toward normalizing policy rather than promoting growth. Very low nominal interest rates were mistaken as proof that policy was, if anything, too loose. However, negative inflation meant that real interest rates were not so low and in fact rising. Plus, the interest rate had only been lowered a total of 50 basis points over five years, and money and credit growth were still extremely weak. An improvement in on-year GDP expansion to 2.6% by late 1999 readied officials to try a rate increase, which they undertook in August 2000. When the economy floundered, officials returned to a policy of zero interest rates (ZIRP) in 1Q01, only this time with progressively stimulative quantitative easing over the ensuing five years. ZIRP ended in March 2006 at the first sign of positive core CPI inflation, and for a third time, the economy reacted poorly to an attempt to snug fiscal or monetary policy. BOJ officials could only manage two rate hikes of 25 basis points each in July 2006 and February 2007.
Then came the world recession. On-year Japanese GDP growth swung from +3.5% in 1Q07 to negative 8.9% by 1Q09, and deflation returned. Just two rate cuts of 20 basis points each were implemented in the autumn of 2008. Some quantitative easing has been tried since then but nothing comparable to the scale done in 2001-6. While GDP in the first quarter of this year was 4.6% higher than a year earlier, growth for the whole ten years to 1Q10 had averaged 0.7% per annum, half as much as in the previous ten years, and deflation still persists.
Despite a speedier response from Fed officials than the BOJ, the U.S. recovery has looked fragile and dependent on policy support, which the public wants taken away. It looks similar to what seemingly happened in Japan. The mention of deflationary risks in the FOMC indicates that Fed officials may be drawing the same connection, as well as what happened in the United States after 400 basis points of very gradual and predictable rate tightening during the two years to mid-2006. Even with such utmost care, a speculative U.S. housing bubble was burst, and the rest is history. The U.S., like Japan, has already demonstrated an inability to manage an attempted normalization of credit policy following an extended period of extremely low interest rates. It could be that such experiences change the DNA of an economy in fundamental ways not fully appreciated and severely compromise their immune systems to external shocks.
Copyright Larry Greenberg 2010. All rights reserved. No secondary distribution without express permission.
Tags: Bank of Japan, FOMC, United States
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