If you want to know why the US economy risks turning Japanese, look no further than the Federal Reserve’s swelling balance sheet.
The US central bank’s efforts to rescue a Covid-19 ravaged economy have long since taken it into uncharted territory. In March, its balance sheet expanded past the US$5 trillion mark, matching the Bank of Japan’s.
This, in a nutshell, is why the Dow Jones Industrial Average is not crashing, even as the US races toward 7 million coronavirus cases and over 200,000 deaths.
As America gets sicker and sicker and the economy stumbles, Federal Reserve Governor Jerome Powell has upped the dosage of the Fed’s monetary medicine. So much so it’s allowing stocks to defy financial gravity.
Just like Japan, where the Nikkei 225 Stock Average is, somehow, up 7% over the last year.
This “Powell put,” or Powell’s willingness to rescue markets at all costs, has been the Bank of Japan’s strategy since the 1990s. The BOJ’s consistent interventions since then came to influence the Fed, European Central Bank, Bank of England and others in dangerous ways.
Today’s “Kuroda put,” named after BOJ Governor Haruhiko Kuroda, is the most forceful one in Tokyo’s history. But it’s inspired by the BOJ’s monetary gymnastics that started with Yasuo Matsushita, the governor from 1994 to 1998.
It was on Matsushita’s watch that Yamaichi Securities, one of Japan’s big four brokerages, collapsed, spooking global markets. That was in November 1997, at the height of the Asian financial crisis toppling Thailand, Indonesia and South Korea. At the time, markets worried Japan, then the No 2 economy, might crash too.
Matsushita’s team helped avoid that fate with assertive monetary maneuvers. By the time Masaru Hayami replaced him in 1998, the deflationary pressures still bedeviling Japan today were becoming entrenched.
In 1999, his BOJ cut interest rates to zero. Two years later, Hayami pioneered the quantitative easing with which both Kuroda and Powell are still toying today.
And that, arguably, is the problem. QE was always meant to be an emergency tool. Like a defibrillator, QE aimed to shock a financial system back to life. After that, doctors inject medications intravenously until a body is ready to come off life support.
Rather than putting away the monetary defibrillators and IVs, the BOJ administered ever bigger jolts and doses.
The BOJ treatments grew far more aggressive on Kuroda’s watch since 2013. Now that Japan’s economy is flatlining anew – plunging at a 28% rate in the April-June quarter – the odds are the BOJ will soon come up with an even more potent drug.
The problem, of course, is that it’s taking the onus off new Prime Minister Yoshihide Suga to upend an aging and rigid economy.
That’s why Abenomics flopped. If you’re Shinzo Abe, prime minister from 2012 until earlier this month, who does the hard work to reduce bureaucracy, modernize labor markets, rewrite tax policies and empower women when the Kuroda put has your back?
This same vicious cycle is nudging the US toward mediocrity. In the late 1990s, about the time the BOJ was regularly refilling the punchbowl, then-Fed Chairman Alan Greenspan, too, began giving Fed bailouts a try.
His replacement, Ben Bernanke, went the QE route amid the 2008-2009 Lehman Brothers crisis. Powell is now supersizing both the “Greenspan put” and the “Bernanke put,” expanding the Fed’s balance sheet exponentially.
In doing so, Powell is generating a powerful stock rally eerily divorced from economic reality. As the “Powell put” gobbles up government and corporate debt and stocks via exchange-traded funds, he’s allowing Wall Street to defy financial reality.
What Powell has done, says Dave Nadig, research director at ETF Trends, is “convince the Street that they would be the buyer of first and last resort, and bringing investors along for the ride.”
And to ignore economic reality. The idea that the Dow Jones Industrial Average is a buy as Americans get sicker and sicker, the US contracts at a 33% rate and Donald Trump’s re-election strategy is to strangle the second-biggest economy, takes cognitive dissonance to new levels.
Yet with Powell acting as Trump’s ATM, the White House has zero incentive to build economic muscle at home – to increase innovation and competitiveness. It also has investors chasing the market higher and higher, creating upward momentum where none is warranted.
It’s a very useful dynamic for Trump, who can point to stock gains to perpetuate his Covid-19-is-a-hoax conspiracy theory. Less so for the broader economy, which lost tens of millions of jobs since January.
The Powell put is essentially creating a titanically large pyramid scheme. The BOJ, remember, has been adding fresh liquidity to the economy for 20 years now. And in ever bigger doses because central bank credit, like pharmaceuticals, required bigger and bigger jolts over time.
And still Japan is grappling with deflationary forces, tepid wage growth and by far the biggest public debt load among developed nations.
Japan is, in other words, stable, but still in need of semi-regular medical attention. The extent to which the Kuroda put, and all the inventions of BOJ leaders of the past, has weakened Japan Inc’s defenses is apparent on how quickly the economy hit a Covid-19 wall.
Now, as Suga consolidates his power, he’s hoping the BOJ administers an even more potent monetary cocktail. On Wednesday (September 23), Suga and Kuroda met. Afterward, Kuroda said “we agreed that the government and the BOJ will conduct policy measures by sufficiently communicating with each other and fully working together.”
Get your defibrillator machines and IV bags ready. Kuroda also said “it’s desirable that exchange rates move stably reflecting economic fundamentals.” That suggests a fresh effort to cap the yen in ways that are sure to irk US President Donald Trump, who long threatened to add a currency front to his trade war.
It also suggests the Powell put could have a busy five or so weeks between now and the November 3 election. With US Covid-19 deaths exceeding 200,000 and growth slumping, Trump will need all the cover from Wall Street he can get. Any sign that the yen is trending lower versus the dollar is sure to set Trump off, too.
History will show whether Powell, the first non-economist ever to run the Fed, is acting wisely or recklessly. These are, after all, truly extraordinary times, says economist Ethan Harris of Bank of America. Powell’s overriding concern, Harris says, is “avoid getting trapped in a permanent low-inflation world, so-called ‘Japanification.’”
Or is it too late? Matt Brill, a portfolio manager at Invesco Fixed Income, worries “we are certainly on a path to Japanification.” The Fed, he says, “is going to keep rates very low for a very long time.”
Yet count JPMorgan Chase analyst Fabio Bassi among those who see this risk as a remote one. The US, he argues, won’t get trapped where Japan is.
“Taking policy rates to zero with strong forward guidance is only a necessary condition in the road to Japanization of the yield curve,” he argues. The US “is furthest away as the market attributes maximum credibility to the Fed in its reflationary exercise.”
The problem, of course, is what happens when two of the globe’s most powerful monetary authorities engage in a race to the bottom on rates. When the BOJ acquired a taste of such competition, its economy reacted negatively.
Since 2008, says economist Robin Brooks of the Institute for International Economics, there have indeed been episodes “when the BOJ was out-doved by other central banks, putting appreciation pressure on the yen and worsening deflation.”
That may be about to happen anew as 2021 approaches. Already you have two central banks with balance sheets together topping $10 trillion looking to buy even more assets. That means more public support for bonds, stocks and levels of moral hazard risks history has never seen before.
Pyramid schemes don’t tend to end well. That may be doubly true as the Fed and BOJ work frantically to keep two giant ones going. Talk about a bubble in bubbles.