Why has the Bank of Japan cut interest rates which were already so low? Has the Shadow MPC revealed the intentions of the real one?

5th October 2010 by Shaun Richards

Yesterday saw something of a retracement in equity markets as the Dow Jones Industrial Average fell some 78 points to 10,751 with the fall mostly caused by a downgrade for Microsoft profits. This means that this mornings rally in the Nikkei 225 equity index of some 137 points to 9518 has made a substantial dent in the spread between the two indices which has now fallen to 1233 some 200 points narrower than yesterday. The rally in Japan was caused by some policy action by the Bank of Japan which was overall a surprise.

What has the Bank of Japan done?

There had been some debate ahead of the Bank of Japan’s meeting as to what it might do, usually followed by a debate about what it can do! For those who do not follow Japan the second part of the sentence is caused by the fact that in its long struggle with the “lost decade” in Japan the Bank of Japan has tried virtually everything often more than once. However this morning we got three main announcements.

In a unanimous vote, the Bank of Japan’s nine-member policy board set its overnight call rate target to a range of zero to 0.1 percent. The central bank had not changed the rate since December 2008, when it was set at 0.1 percent. In addition it stated that it would look at establishing a temporary 5-trillion-yen ($60 billion) fund to purchase various financial assets such as government securities, commercial paper and corporate bonds in an attempt to stimulate the economy by lowering longer-term interest rates or what are more commonly called asset purchases or Quantitative Easing. The central bank will offer another 30 trillion yen ($359 billion) through its loan program. This programme which provides cheap loans to financial institutions has been expanded several times now since its inception.

Why has it done this?

“Although Japan’s economy still shows signs of a moderate recovery, the pace of recovery is slowing down partly due to the slowdown in overseas economies and the effects of the yen’s appreciation on business sentiment,”

So the Bank of Japan is concerned about the slowdown in the Japanese economy which has recently become apparent. It may also have been concerned by the way that the Yen had remained strong versus the US dollar even after its currency intervention and so this policy may also be looking to weaken the Yen’s exchange rate. In addition we have had a sign of one of my themes that of reduced or even non-existent central bank independence as Your Party, an opposition group, plans to submit a bill in the Diet session running through December that would give the government a greater role in Bank Of Japan policymaking. There has been talk of such a policy from members of Naoto Kan’s ruling party as well so political pressure may well have played its part in these moves. In this sense the Bank of Japan may well be fighting for its life.

In the battle of realpolitik I do have one thought. If the politician’s do succeed in getting full control over the Bank of Japan who will they have to blame if (some might say when) things go wrong? If I was Governor of the Bank of Japan I would feel that pointing this fact out would be my strongest defence. Again for those who have not followed the situation recent economic policy in Japan has become something of a blame game with politicians blaming the central bank and the central bank blaming politicians.

Will it work?

We have here one of the policy options that Ben Bernanke mused over in his speech at Jackson Hole back in August that of reducing interest rates to zero. It escaped me at the time exactly what good would come from this when rates were already so low. In Japan the maximum move is 0.1% from 0.1 to zero. In a country where interest rates have been so low for so long the effect is going to be very small if one can be measured at all. This type of ZIRP or Zero Interest Rate Policy has not had the effects that its proponents expected and has led to some suggesting that we now need a NIRP or Negative Interest Rate Policy. Fortunately Japan has not tried this as to be frank it sounds more than a little desperate to me.

If we examine the prospect of some new asset purchases by the Bank of Japan any effect is likely to be small. You see such a policy is used to reduce long-term interest rates to hopefully stimulate the economy. However Japanese long-term interest rates are already much lower than anywhere else. For example her ten-year government bond yield fell yesterday from 0.95% to 0.9% which if it was going to do much good the falls in the past to 0.95% should have done so should they not? Japanese 30 year government bond yields are only 1.79%. As I have reported in the past in the section I have on the Japanese economic crisis  one of the main weapons of QE has done little good and looking further afield I feel that it is a lesson other policymakers should have learned from. In effect this is part of my critique of Adam Posen’s recent speech that I published here on the 29th September as I feel he needs to explain why he feels that the results will be different this time if he is allowed to set sail on the good ship QE2.

As to the loan plan well that has been modified several times by the Bank of Japan and the modifications have not been because it has been working well! In essence this performs the role of something to announce rather than a policy option which anybody actually believes in.

Further Comment

As you can see from my analysis so far these moves are unlikely to have a direct impact of any great size on the Japanese economy however I do not believe that the rally in Japan’s equity market was entirely misplaced. This is because there will be some indirect effects. For example if we look at the exchange rate of the Yen we see that it has weakened this morning against the Euro to 114.81. Unfortunately it hasn’t moved much against the US dollar or to be more specific after a fall it is already back to where it started. However this is a very muddy area as the US dollar is weak at this time due to the fact that many expect it to introduce more Quantitative Easing itself so it is hard to figure out any trend from the data as there are some many cross-currents. I wrote on this subject on the 23rd and 29th of September and one of the questions I posed, Are we repeating the mistakes of the 1930s? Comes to mind again.

In addition with Japan still mired in disinflation with prices falling and negative inflation being reported for some 20 months now it is possible that one of the side-effects of Quantitative Easing an increase in inflation may actually be welcome in Japan. I have some further thoughts on this subject from the Shadow Monetary Policy Committee in the UK which meets under the auspices of the Institute of Economic Affairs.

The Shadow Monetary Policy Committee

This meets each month usually on the weekend before the actual MPC meets and gives it policy pronouncements. Let me first say that it voted 6-3 on interest rates with the majority voting for no change and the dissenting 3 voting for a rise to 1% because they were concerned about inflation. However something else caught my eye.

Finally, virtually all the SMPC members, including most of the rate hikers wanted a second round of Quantitative Easing (QE), with a further £50bn of asset purchases being the most widely recommended figure.

This was an interesting view because few actually expect any change this week from the Monetary Policy Committee on Thursday but its shadow was almost unanimous on expanding Quantitative Easing. With the Bank of Japan planning a move as discussed earlier this could become a worldwide trend particularly if the Federal Reserve joins in too at its policy meeting on the 2nd and 3rd of November. However the views of one of the members Andrew Lilico attracted my attention and the emphasis is mine.

Critics suggest that printing additional money at this stage would: (a) threaten the Bank of England inflation target’s credibility, given that CPI inflation is well above target and has been so for most of the past four years; and (b) would be inflationary down the line. But the appropriate response to point (a) is that the Bank’s inflation target has no credibility to lose.

Indeed he goes on to suggest that creating inflation is an outright objective of Quantitative Easing.

The response to charge (b), that more QE will be inflationary, is ‘you are quite correct – that is the idea’…………There will be a modest inflationary price to pay on exit – perhaps annual CPI inflation will reach 6% and RPI inflation might reach 10%. But that is a problem for 2012 or 2013.

At least he is being honest but I would challenge his definition of the word “modest”. Also if you look at UK economic history increases in inflation on such a scale are usually very hard to get rid of and at times have led to considerable inflation overshoots as inflationary expectations have become entrenched. These overshoots have often required quite severe measures to remove them. As you can imagine this is a policy prescription which fills me with trepidation as we are supposed to be in a recovery not running the risk of having to tighten again. To my mind this type of strategy could turn out to be one of the worst examples of “kicking the can down the road”. If nothing else his 2012 and 2013 means he can’t even kick it very far!

Finally we get his view on the inflation target.

Meeting the inflation target has clearly not been a key driver of policy since the financial crisis began. It is an irrelevance. 

Seeing as the job of the Monetary Policy Committee is to hit the inflation target one might reasonably wonder what Mr.Lilico thinks he is supposed to be doing. It appears that he thinks he can do more or less what he likes and my purpose in introducing this section is duofold. It gives us a possible insight into the announcement today made by the Bank of Japan but also is likely to be representing the views of some members of our own Monetary Policy Committee.


It appears that the view that inflation can easily be controlled if it occurs has become somewhat entrenched in our country’s economic community and in particular in those that have the power to influence events. I suspect that Mr.Lilico is advancing a view that actual members of the MPC have kept quiet. It is not my view that inflation is out of control yet but it has consistently overshot its target in recent times and there are other dangers than deflation awaiting us as we move forward. I have before discussed the alternative of stagflation for example. I would like to repeat my statement from my analysis of Adam Posen’s speech.

Also I have a further thought and it does indicate quite a change. As the role of the Monetary Policy Committee has changed and expanded more than could have been forecast when it was introduced in 1997  there need to be new checks and balances on its power. My suggestion for a change is that MPC members should stand for election as they are currently much more powerful than many of our elected representatives.

I sent this suggestion to my Member of Parliament and will let you know if she gives me the courtesy of a reply. I got a favourable response on the economists and analysis section in the Financial Times.

QE and The European Central Bank

As today has been QE day I can finish off by saying that we now have a concrete reason why the peripheral government bonds in the Euro zone have been rallying. The ECB has announced that it spent some 1.384 billion Euro’s on such purchases last week. This means that in total the Securities Markets Programme has spent some 63.5 billion Euros on such purchases since it was announced on May 10th. One needs to be slightly careful in saying that purchases on the week rose tenfold as the numbers record settled trades and the ECB may sometimes delay settlement to confuse us. But the trend is clear and the rumours of purchases of Irish government bonds look ss if they were true.This puts a slightly different slant on the improvement.

19 thoughts on “Why has the Bank of Japan cut interest rates which were already so low? Has the Shadow MPC revealed the intentions of the real one?”

  1. Ian says:

    Your blog is my favourite internet reading!

    The idea of electing the MPC members is excellent! They have long since ceased to be a technical body and now think and speak like politicians, with a broad redistributive mandate.

    On Japan, I remain to be convinced that being “mired in disinflation” is as bad as it sounds. Do you know of any reliable figures comparing changes in GDP per capita in, say, Japan, the USA and the UK over the past 20 years?

    1. Ian says:

      … of course, I mean real GDP per capita.

      1. Paul says:

        Firstly, I’d like to echo Ian’s comments on the quality of your blog and the comments posted to your blog. I probably have to much time on my hands and lurk too long on ideologically-driven sites where the comments largely comprise an exchange of abuse!

        It would be interesting to know what the “real” impact of deflation has been in Japan. What has happened to real disposable income, social cohesion, longevity and GDP per capita growth compared to other developed countries ? What has happened to public and private debt levels and is the status quo sustainable ?

        Given the level of public and private debt in the UK, I’d guess that modest sustained inflation of the order of 5% would be the least painful way of reducing debt in real terms. Comparisons with the 1970s don’t stack up so far as I can see because the labour market is so different: much weaker unions, a huge pool of unemployed people and the free movement of labour within the EU. Therefore, I suspect that the risk of inflation getting out of control is not so great but that, of course, relies on a competent chancellor and BOE.

    2. Thank you Ian, please feel free to spread the word so to speak if you get the opportunity. I have reached the phase where I am looking for more publicity so that I can challenge things….

      As to the mired in disinflation view this,as ever, is rather complex. If we look at Japan there is academic dispute over how much her prices have actually fallen. Fortunately the situation is not so bad that we have anyone arguing that they have not fallen. The reasoning goes as follows. Japan uses a different system for addressing import prices than she does for addressing consumer prices. If the import price system was used for consumer prices then we would have had lower prices or more disinflation. This does not sound good but if you allow for it and say that nominal GDP figures are the same then real GDP suddenly becomes higher. So more disinflation creates higher real GDP growth! Before anyone rushes to chart this or create a theory based on it this is a statistical fluke but illustrates my point. Before we even get to international comparisons we have to filter out a lot of noise on Japan’s own figures. Just to add to the confusion the system was changed a year ago..

  2. Drf says:

    Hi Shaun, “Seeing as the job of the Monetary Policy Committee is to hit the inflation target one might reasonably wonder what Mr.Lilico thinks he is supposed to be doing. It appears that he thinks he can do more or less what he likes…” I think you are correct, and not only with respect to the Shadow MPC.

    There has been for some time a general trend for individuals to have lost the ability to understand what a remit or terms reference are, what they are for and how they ought to be enacted and obeyed. Too many individuals today lack self discipline and are unable to work towards any specific objective, instead becoming befuddled with insignificant factors or minor goals and going off at a tangent! This is above all true of the MPC, to stray into regions where they have never had any authority.

    At the end of the day though, it is all about leadership and management. If those at the top do not take the proper action when those lower down fail to do their duty, then the whole pyramid collapses. That is essentially what has happened, and it is largely due to the fact that those now at the top do not have the wisdom, skills and knowledge to do the jobs adequately, which they have appropriated. They have risen to beyond their level of competence.

    1. andy of yarm says:

      As a nation we only promote those that show little dedication to the cause. Applicant’s with CV’s who have worked many years for a limited number of employers are routinely overlooked for those that spend 2-3 years per employer; promiscuity is mistaken for experience.

      So we are left with leaders who can only think in terms of 6-12 months on,after that they expect to be elsewhere.

      1. “So we are left with leaders who can only think in terms of 6-12 months on” Some might think that such a view on our leaders qualifies you to be an optimist Andy!

      2. Paul says:

        Appearance and the ability to talk confidently and glibly about topics about which one is unaware of one’s own ignorance go a long way too!

        The lack of what used to be called ‘nous’ in high places in both the public and private sector appals me. The child benefit fiasco is a case in point. It should have been easy to foresee:

        a) the anomalies which Shaun mentioned
        b) the impact on women’s pension credits
        c) the response of the media across the political spectrum
        d) the impact on Conservative core supporters
        e) administrative costs and difficulties which are no doubt why the measure will not come into effect until 2013

        If this measure characterises the level of competence of the coalition government, then we are going to live in very interesting times!

  3. Shireblogger says:

    Thanks again, Notayesman. A number of pairings are coming to life : Osborne’s austerity suits his need to drive down the yield curve whilst DMO issues more gilts ; the consistent talk of banking recapitalisation,liquidity and funding problems going forward point to QE2 ( Mervyn King-style) doing nothing other than bailing out banks yet again and aiding more sovereign borrowing; competititve devaluations scoring home-goals whilst a G7 bond bubble bursts throwing everything in to reverse. I agree, the can is being kicked down the road by a lot of unaccountable people and all I see is volatility.Even positive news could be negative in this new era.

  4. Shireblogger says:

    Hi again,
    Just thinking about the Yen appreciation, one wonders whether we are better off being a domestic demand-led economy mired in inflation with a depreciating currency as opposed to an external demand economy mired in disinflation with an appreciating currency. I then start to wonder what position Germany would be in if they had the Deutsche mark as opposed to the euro. Wouldnt the Deutche mark be as strong as or stronger than the Yen and wouldnt Germany have the problems of Japan. I then thought that Greece,Ireland,Portugal and Spain are doing Germany a power of good at the moment. Fireworks at the G20 I suspect..

    1. Ah the role of Germany in the Euro! This is really a tinderbox as it would clearly have a lower exchange rate without it. However the politicians appear so wedded to their political plans for union that it has blinded many of them to the fact that the Euro is bad for their country in its present form as the exchange rate is too high. Indeed the “wolfpack” were criticised for driving the Euro down! I always thought that this was rather bizarre.

      Germany leaving the Euro would help on this score as presumably the Euro would fall but who would pick up the bills then?

  5. Mac says:

    ‘I have reached the phase where I am looking for more publicity so that I can challenge things….’

    And when we hear honest, common sense answers from the politicos we might start getting somewhere!

    1. Zak says:

      “…And when we hear honest, common sense answers from the politicos we might start getting somewhere!”

      And that will around the time that Satan puts ice skates on his Christmas list, yes?

  6. forbin says:

    sorry , but if all the major debtor countries do QE2 , then aren’t they just inflating away the massive debts ? or does this mean all their QE cancel each others out ?


    1. Hi Forbin
      As I wrote today there is in most countries a tendency to inflation when they indulge in QE. This has not taken place in Japan because there are quite a few differences between her economy and the UK or US. We in the UK seem most vulnerable to inflation. As to Europe it will be interesting to see the effect of their QE programme as it has other implications. Whilst small for the Euro zone the scale of purchases is mounting if you look at the size of the countries whose bonds are being bought so there is a fair bit to consider.

      As to them cancelling out then internationally there may well be an element of this as currencies cannot fall in isolation but domestically the policies do not cancel out if anything they add to each other.

  7. Ian Jones says:

    So the usual way of escaping from too much debt will be followed i.e. inflation. I had wondered if the MPC really believed the Output Gap rubbish or if it was just part of a plan to keep people in the dark whilst they pumped out new money to raise the general price level.

    I do hope the Treasury is putting together a plan for what the MPC will be replaced with as their credibility is shot and 10% inflation would be the end of an independent BoE….

    1. Hi Ian
      I have got in early so to speak with my plan for changes at the MPC,elect them. I guess partly because I feel that their credibility is already shot….

  8. Mac says:

    At the moment yes Zac, but eventually the elasticity of the thin veneer of legitimacy on the surface of so many aspects of governance will snap. Looks to me like the people charged with managing our fiscal matters are cluelessly stuck in some sort of mind warp, using tools which have become outdate or at the very least have little bearing on the contemporary problems we face. How else can you rationalise hailing the mighty Mr B as the saviour of the Western world only a couple of years ago! We need people who can make sense of it to come forward and challenge the inept workings of the Establishment and start to offer some sort of real innovative choices or we will be stuck with the moribund morass of mediocrity which clogs up the system now.

  9. Shireblogger says:

    Notayesman – I note the BoE Q3 bulletin reminds us that 3 and 6 mth Long Term Repo auctions were oversubscribed June-August and that £750-800 billions of term funding for UK banks was due to mature by end of 2012. Is there any research on how this will be achieved?

    I was amused by the QE research conclusion ” Our analysis
    suggests that the purchases [ QE] have had a significant impact on
    financial markets and particularly gilt yields, but there is clearly
    more to learn about the transmission of those effects to the wider

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