There's an old joke in economics that goes: "The questions never change, but the answers always do". The unconventional answers that central bankers have developed over time to solve the lack of inflation (or in some cases deflation) are Quantitative Easing (QE) and Zero/Negative Interest Rate Policy (ZIRP/NIRP). Exhibit 1 below shows the two page document on the Bank of England website that was used to explain QE to the masses. If you don't have anything nice to say, you shouldn't say anything at all…so no comment. In theory, QE was designed to boost asset prices and reduce interest rates as central banks “printed” money (it was actually created electronically) to buy assets (predominantly government bonds) from financial institutions and banks. Lower interest rates would lead to higher borrowing by people and businesses, which would use their borrowings to spend and invest. This, in turn, would create jobs and lead to economic growth.
Exhibit 1: BoE’s Explanation of QE
As we attempt to answer age-old questions by pouring over current financial market developments and real economic results, which are not the same thing despite associations made by less sophisticated investors, it is difficult to conclude that unconventional monetary policy (and QE specifically) has been successful over the long run. Asset prices have certainly gone up since the great financial crisis (GFC) of 2008. Those who had wealth and were invested in financial markets since the GFC generally became wealthier. However, real economic realizations (in terms of inflation, GDP, and wage growth among others) – which ultimately create new wealth – have either been non-existent, insignificant or unsustainable considering what QE was supposed to deliver. On the flip-side, how much worse would those results have been had central banks not backstopped the world? Yes central banks backstopped the world, not just the global banking system or financial markets. See Exhibit 2 for a brief history of unconventional monetary policy actions taken by the central banks of Japan, UK, U.S. and Europe. The potency of the policy that central banks are able to unleash should not be underestimated, even in the present day.
Exhibit 2: A Brief History of Unconventional Policy Actions in Japan, US, UK, and Europe
Source: Bank of Japan, Bank of England, U.S. Federal Reserve, and European Central Bank
For the better part of last year, central banking appeared to be a global game of chicken – a two player game theory model of conflict – where the two players were the U.S. Federal Reserve (Fed) and everyone else (i.e. all other central banks). The game had two possible outcomes:
- Good economic data would lead to a Fed hike which would lead to relent by everyone else.
- Bad economic data would lead to a Fed relent which would lead to additional easing by everyone else.
Outcome number one transpired as the Fed raised interest rates by 0.25% on December 16, 2015. While all other central banks relented for a short-period of time, the subsequent sell-off in risky assets had resulted in a thorough review of the sustainability of the so-called “good economic data” that the Fed used to justify its most recent actions. And so, we once again find ourselves asking when, not if, central banks will double-down on their QE experiments. Although to be fair at this point, it is more akin to tripling-down or quadrupling-down. I know I'm making up words, but they're making up policies...so whatever...anything goes these days! Additional accommodation (i.e. monetary policy easing) by central banks in Japan, Europe and perhaps even the U.S. in the not-so-distant future will work in that it will force investors to pile back into risky assets. However, we shouldn't ask "Will risky assets rally?” We know they will. We should ask "Will the rally lead to real, sustainable economic outcomes?” Sadly, we know the answer to this question too, and so did Albert Einstein: "The definition of insanity is doing the same thing over and over and expecting different results." By that definition, the Japanese are downright psychotic, while the rest of the developed world is lagging by about a decade with emerging signs of neurosis. If you're not convinced, just look at Exhibit 3, which compares the trajectory of 10-year interest rates in the U.S., UK, and Germany since the turn of the millennium (2000) to Japan's 10-year interest rate trajectory beginning a decade prior (1990). While they do not follow each other perfectly, they're pretty darn close.
Exhibit 3: 10Yr Japanese Bond Yields vs Decade Lag of 10Yr US, UK, and German Bond Yields
So the most important takeaway from the last decade of Japan's history is that interest rates, economic growth, wages, and inflation are going anywhere but up. I suppose central banking is no longer a game of chicken. It has become a race to the bottom and we are all catching up to Japan.