The September Meetings of the Bank of Japan and the US Federal Reserve: Indirect Implications and How Consensus May Be Underestimating Inflation

Rarely do central bank meetings attract so much attention, but in a world of low interest rates and subdued inflation, the attention is warranted. The September meeting of the Bank of Japan (BOJ) and the Federal Reserve (Fed) were watched by market participants as harbingers for future indications of monetary policies and as a live assessment of the current economic cycle. Given the BOJ and Fed’s impact on global liquidity levels, the policy tone and direction is expected to ripple worldwide. In the latest meetings, Governor Kuroda launched a new form of easing by pledging to cap 10-year government bonds yields, that is in addition to the current minus 0.1% interest rate and ongoing ¥80trn annual bond buying programme. A few hours later on the same day in the US, Chairwoman Yellen left interest rates on hold while also lowering her guidance for 2017 from three rate hikes to two.

With both economies facing anemic domestic growth, each central bank has embarked on unorthodox monetary policies that have been criticized as being ineffective in offsetting the low inflationary environment. Though the yen initially weakened after the BOJ meeting, the depreciation was pared back due to a shortfall in conviction among traders as well as Yellen’s dovish comments. Market commentary was unanimously critical suggesting that monetary policies have reached their limits and without fiscal measures, the September meetings of the BOJ and the Fed actually achieved little and will be unlikely to spur inflation.

We disagree with the view that policy actions were empty, as most market commentary argued lack of credibility as their underline assumption. Though concur that without structural reform and appropriate fiscal measures, monetary action alone cannot lift either economy meaningfully, we are more positive that announcements from the BOJ and Fed are sufficient to ensure seminal policy changes. We also believe that the prospects of inflation pressure are imminent due to domestic and external factors. The market’s disappointment stems from looking for more direct action from each central bank, and ignoring the indirect implications, in our view.

Firstly, the BOJ and Fed reemphasized their commitments to maintain polices, be it Japanese inflation or US wage growth, suggesting that both central banks would tolerate an overheated economy. While Kuroda promised to exceed the 2% inflation target, Fed Chair Yellen reiterated that the case for higher interest rates had strengthened, but left borrowing costs on hold given lower downside risk. Helping them to reach their targets, evidence of tightening domestic labour markets is visible in both Japan and the US, where annualized wage growth is exceeding inflation which bodes well for domestic demand.

Secondly, there is a compelling argument that the BOJ’s cap yield strategy achieves more than adding incremental flexibility to Kuroda’s current scheme. Indirectly, the cap yield strategy prioritizes bank profitability, remedying criticism of Kuroda’s negative interest rates set back in January this year. By removing profitability drags, Kuroda alleviates the overhang on the banks which will be conducive towards transmitting the policy into the real economy. A positive slope yield gives viability to longer end projects where loans match project lengths, encouraging banks to utilize short-term deposits for long-term tenure.

In the US, Yellen’s pause reflects that the risk associated with keeping rates low is less than the potential impact of raising interest rates too early and often. Revising down her guidance for normalization in 2017 while maintaining her view that the economy can absorb a rate hike is a clear declaration that a December hike is highly likely. This provides clarity for the next five quarters, supporting a time frame for public investment that has been sidelined due to political constraints. Both Kuroda and Yellen have essentially established parameters that invite greater public spending as a conduit to lift the economy.

Thirdly, markets in general may be underestimating inflationary pressures. Macroeconomic forces including a tightening in the labour market or a commodity price recovery could occur due to a fading base effect or supply disruption.  But inflation is also an efficiency proxy. For most of this year policy makers have underestimated the rising populist and anti-globalization rhetoric. As protectionism becomes more mainstream political compromise shifts towards a focus on domestic initiatives. This is evident in the populist rhetoric in both Western Europe and the US, where any opprobrium on free trade policies may well lead to higher prices.

The BOJ and Fed have provided considerable support within the limit of their mandates, but will need political will to push forward structural reform and fiscal policy to drive growth. As domestic yields remain low, Emerging Asian equities have benefited from the yield trade given positive real rates and healthy current accounts. But as Emerging Asian economies continue to push reform measures that are absent in developed markets, it is clear that equities will remain attractive given better growth dynamics, particularly in the larger economies of China and India, as well as ASEAN. 

An ever-present risk to our assumption is the extent to which other alternative policies can be implemented, as expansionary monetary growth is anodyne to much needed structural reform. For Japan, a rising yield curve is normally a function of a healthy economy, but could be misread and delay the actual pace of restructuring. In the US, current labour shortages could well be tighter than Yellen’s expectations, providing even less maneuvering space than anticipated.