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Only Haruhiko Kuroda can feel Jerome Powell’s pain.
In March, Federal Reserve Chairman Powell joined his Bank of Japan counterpart in the US$5 trillion club. Eighteen months earlier, Governor Kuroda became the first governor to expand any central bank’s balance sheet beyond that record-breaking level.
Now, the world’s most powerful monetary authority has done the same. And already it’s facing the same stark reality check: running out of ammunition sooner than expected, which in turn presents markets with the possibility of massive fallout.
In recent days, a torrent of analysts and former Fed officials have stepped forward to warn that the US has churned as much monetary stimulus as it possibly can into its economy. That’s worrisome news for Wall Street’s Fed-driven bull market. And for a Dow Jones Industrial Average now down 3.7%, year-to-date.
None have raised more eyebrows than William Dudley, who ran the Fed Bank of New York from January 2009 to June 2018. In a series of recent interviews and op-eds, the former Goldman Sachs economist has been calling the Fed’s bluff.
“No central bank wants to admit that it’s out of firepower,” Dudley wrote in a Bloomberg opinion piece. “Unfortunately, the Federal Reserve is very near that point. This means America’s future prosperity depends more than ever on the government’s spending plans – something the president and Congress must recognize.”
Dudley’s point is that even if the Fed did more – considerably more – it might not jolt the economy as much as Powell or US President Donald Trump hope. Financial conditions, Dudley notes, “are extremely accommodative. Stock prices are high, investors are demanding very little added yield to take on credit risk, and a weak dollar is supporting US exports.”
Interest rates on a 30-year mortgage stand at about 3%, or less. The Fed pushing those rates down another, say, 0.5 percentage point, wouldn’t get much traction in a housing market that’s holding its own amid the Covid-19 fallout.
Yet Japan’s experience offers some vital clues to a Fed facing the limits of what conventional monetary easing can, and can’t, do. Here are four lessons Powell’s staff should be heeding.
1: Constant reinvention is vital
Since 2001, when then-Governor Masaru Hayami pioneered quantitative easing, a succession of BOJ leaders expanded the experiment. Each announced bigger and bigger purchases of government bonds and stocks via exchange-traded funds and other assets aimed at flooding markets with liquidity and restoring growth.
Over time, though, Japan found it had more money in circulation than uses for it. This disconnect starved Tokyo of the multiplier effect that makes money policy changes so potent.
The trouble was that the liquidity jolts aimed at defeating deflation treated the symptoms of Japan’s decades-long malaise, not the underlying causes. Those causes are a lack of economic confidence in the future and an aging population that favors saving and frugality over consumption.
Japan, in other words, has been aiming at the wrong target.
Its aim is generating 2% inflation, when really it should be targeting 2% wage gains or 2 percentage-point increases in overall gross domestic product. The Fed needs to recalibrate its asset purchases in ways that get markets’ attention and focus on a more specific goal.
Powell’s team can do so by adopting the negative-rate policy which the BOJ has been employing since 2016. The move would roil markets at first. But with some technical policymaking behind the scenes, these shocks can be overcome. With more targeting and aggressive asset purchases, the Fed could have greater success with below-zero rates than the BOJ.
The Fed also could take steps that the Kuroda BOJ hasn’t. It could, for example, add a quid-pro-quo dynamic to its corporate bond purchases. It could agree to load up on the IOUs of companies that pledge to retain staff, increase salaries and invest in future growth.
Another option is to propose joint stimulus moves with Congress and the White House. This, in a nutshell, is why government spending is far more important as 2021 approaches.
Yet the Fed can supercharge the process by accompanying the next fiscal stimulus moves with fresh, and carefully targeted, monetary artillery. As Powell said on October 6: “The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side.”
Japan’s experience more than validates Powell’s argument.
2: Get cash directly to households
As of now, US consumer price pressures are benign, a sign that household and business confidence remains weak. “The bottom line,” says analyst Will Denyer of Gavekal Research, “is that inflation is rebounding, but does not yet threaten a Fed response.”
So there’s plenty of room for more dollar printing. The challenge, Dudley notes, is one of replenishment.
“The stimulus provided by lower interest rates inevitably wears off,” he explains. “Cutting interest rates boosts the economy by bringing future activity into the present. Easy money encourages people to buy houses and appliances now rather than later. But when the future arrives, that activity is missing. The only way to keep things going is to lower interest rates further – until, that is, they hit their lower bound, which in the US is zero.”
An easier way is to secure authority from Congress to dispatch regular cash allotments to households. Consumers worried about future income will save any central bank funds flowing into their accounts. So the Fed could arm households with US$1,000 monthly disbursements that won’t be replenished until they’re fully spent.
Think of it as a temporary universal basic income strategy.
Powell must heed the pledge by former European Central Bank President Mario Draghi to do “whatever it takes” to bend the deflationary mindset curve.
Kuroda talked of doing so, but stopped well short of actually doing it. Powell’s team should n0t repeat the BOJ’s timidity.
3: Beware moral hazard
Since 2013, Kuroda’s BOJ aggressively expanded the central bank’s balance sheet, which now exceeds annual GDP. By June 2018, the BOJ ranked among the 10 biggest shareholders in nearly 40% of listed Japanese companies.
Since the coronavirus hit, the BOJ has tightened its tentacles around Japan Inc. Last summer, it doubled its annual purchasing target for stocks to 12 trillion yen ($115 billion). The risk, though, is how all this largess takes the onus off CEOs to raise their competitive and innovative games.
The Fed has been toying with QE on and off since the 2008 Lehman Brothers crisis. Then-Fed chief Ben Bernanke, a student of Japan’s lost decades, turbocharged the policies Hayami devised in the early 2000s. Now, of course, Powell is blurring the lines between where the Fed’s balance sheet ends and the private sector begins.
None of these monetary interventions make Corporate America more competitive, efficient or productive. Propping up share prices hasn’t generated new waves of innovation or made CEOs more answerable to shareholders. On the contrary, as Japan Inc has proven again and again, it shields underperforming companies and governments from accountability.
Giant waves of BOJ cash over two decades deadened the urgency for change. Its support amounts to a huge block of ownership that is not pressuring companies to invent new products and technologies or to diversify boards, as per Tokyo’s reform drive.
As Japan shows, a central bank commandeering free markets can backfire spectacularly. Rather than reawaken an economy’s “animal spirits,” it can lull them into complacency.
The Fed must find ways to incentivize American CEOs to take risks and see the central bank more as a safety net than a sugar daddy.
4: Plot an exit strategy
The key to avoiding complacency is to make sure corporate America knows that this profligacy isn’t permanent. It was William McChesney Martin, the larger-than-life economist who led the Fed from 1951 to 1970, who famously observed that a central banker’s job is to “take away the punch bowl just as the party gets going.”
Leaving the liquidity taps flowing too long is what leads to addictive behavior and economic underperformance. Japan remains “Exhibit A” for how quickly banks, companies, consumers and elected officials politicians get used to free money – and use it as a central crutch.
Too much imbibing, in other words, warps not just market dynamics and goalposts, including yield spreads and credit risks. It also impairs the judgment of fiscal policymakers, CEOs and investors alike.
The Fed is “increasingly on what I call a no-exit paradigm,” says economist Mohamed El-Erian at Allianz SE.
Part of the problem is that virtually every sector, institution and financial practitioner in the US has just about forgotten what happens when the Fed yanks away the monetary punchbowl.
As former Fed Governor Randall Kroszner sees it, the titanic borrowing by governments is “… going to make it difficult for central banks to raise rates when they feel the need to do so,” because of the market fallout it will cause.
The Fed, in other words, may already be trapped along with the BOJ, in a web of its own making.
This cries out for global cooperation. The Fed, BOJ, ECB, Bank of England and other QE enthusiasts should be meeting to compare notes and to plot exits that are transparent, orderly and phased.
Done this way, it could increase global confidence that major economies are ready to come off life support. And kick addictions to punchbowls which are fast losing potency.