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September 19, 2016

The World’s Most Important Central Bank (It’s Not The Fed)

by Amareos.

Ever since the Great Recession, the world economy has been suffering from a malaise that has come to be known as the “New Normal”; one where real activity is weaker than anticipated and where sustained positive inflation rates in line with central bank mandates have proved elusive. These are afflictions that the Japanese economy has been suffering from for over two decades. As a result, many of the unorthodox monetary policy measures adopted by the BoJ have subsequently been adopted by their peers – a point made recently by Claudio Borio, Head of the Monetary and Economic Department of the BIS[1]. Hence, in a very real sense, Japan’s central bank can (and should be) considered a monetary policy vanguard.

Japan’s “lost decades” have been well documented, but it is worth reminding ourselves of the growth profile of the economy (or rather lack of) over the past twenty years. As can be seen in the exhibit below, the level of nominal GDP recorded last year was exactly the same as that in 1995. Given the level of real GDP has increased by a cumulative 16% over this period (admittedly not a robust performance) this serves to underline the magnitude of the deflationary undertow present in the economy.

Exhibit 1. Japanese Gross Domestic Product – JPY tr


Source: IMF

The best explanation for this prolonged, tepid, macro performance came from Richard Koo, Chief Economist of the Nomura Research Institute, who coined the phrase “balance sheet recession”. What differentiates this from a regular “cyclical” recession is that the economy is negatively impacted by a deflationary drag as a result of the private sector paying down high debt levels accumulated in the preceding boom[2]. In the case of Japan, the culprit was the corporate sector, which ran persistent net financial surpluses over the past two decades.

One thing that follows from the way national accounts are constructed is that the following identity must always hold (it is, after all, an identity not a theory).

Current Account Balance = 

Net Corporate Saving + Net Household Saving + Government Budget Balance

Even though Japan has benefited from a sustained current account surplus, which serves as a mitigating factor, the behaviour of the corporate sector meant that the Japanese government was effectively compelled to run a persistent – often sizeable – budget deficit (see exhibit below).

Exhibit 2. Sector Financial Balances (% GDP) – Japan


Source: IMF

Unfortunately, the combination of sustained government budget deficits and sluggish nominal GDP growth has put Japanese government debt dynamics on an explosive upward trajectory. Gross public sector debt in Japan stands just a shade under of 250%, and even on a net basis it is an eyewatering 126%.

As the implementation of Abenomics, which began in 2012, made plain rectifying the ultimately unsustainable combination of a high, monotonically increasing, government debt/GDP ratio and sluggish growth has become a top economic imperative for Japan[3].

That the Japanese favoured the reflationary thrust of Abenomics is hardly surprising considering the alternative approaches to reducing the fiscal burden; namely, running a sustained government budget surplus or reneging in some form on their existing liabilities (i.e. debt restructuring or in extremis outright default).

Fiscal consolidation is not only politically unpopular (and no one should ever underestimate a politician’s desire to remain in office) but given the level of public sector debt in Japan the probability that the debt trajectory improves solely on the basis of fiscal consolidation is as close to nil as you can probably get.

Reneging on existing liabilities is also politically unpopular, especially given the high level of domestic ownership of the JGB market, which would mean it would be indistinguishable from a wealth tax[4].

Interestingly, our crowd-sourced measure of debt default sentiment has remained steadfastly low over recent years – a clear indication that the public at large does not worry about this option being adopted. (Although the chart shows some movement over the 6-year time period please bear in mind the tight range of the scale).

Exhibit 3. Debt Default / Political Risk Indicator – Japan



While progress on the reform front (the so-called third arrow of Abenomics) has been – let us be generous – slow, the same cannot be said of monetary policy. Indeed, the absence of productivity-enhancing reforms has arguably put even more pressure on the BoJ.

As can be seen in the exhibit below, under Governor Kuroda, the central bank’s balance sheet has soared to 90% of Japanese nominal GDP. This is simply enormous. To put it into context, assuming its asset purchase programme remains unchanged, the ECB’s balance sheet is on track to rise to 35% of GDP by year end and the Fed’s balance sheet seems almost meagre at just 25% of GDP[5].

Exhibit 4. BoJ Balance Sheet (% GDP)


Source: BoJ

What’s more, because of the scale of its operations, the BoJ has been forced to purchase assets that are typically well beyond old-school central bank remits[6], and in some considerable size; something that has not gone unnoticed, or uncriticized.

Despite such aggressive monetary policy action, the rise in private sector inflation expectations, which we track used crowd-sourced sentiment about future inflation, witnessed in the first few years of Abenomics have failed to be sustained and actual CPI inflation is once more undershooting the mandated 2% CPI inflation goal.

In short, to-date Governor Kuroda has failed to achieve his stated monetary policy objective and in late July he promised a “comprehensive assessment” of its monetary policy programmes at the next policy board meeting slated for September 20-21st[7] with a view to achieving the 2% inflation target “at the earliest possible time”.

Despite such ostensibly strong language, Japanese sentiment towards future inflation and economic growth have risen in recent weeks, but only modestly (see exhibit below). Similarly yields on the nominal 10-year JGB yield have drifted upwards over the past several weeks, but are still in negative territory. Such readings are a clear indication that the crowd is not anticipating “shock-and-awe” tactics from the BoJ later this month.

Exhibit 5. Economic Growth and Future Inflation Sentiment – Japan.



One policy idea that has be floated ahead of the September meeting, in addition to widening the basket of assets the BoJ would be able purchase, is for the creation of non-marketable zero-yielding perpetual government bond. This is an interesting set of characteristics. We, for one, have a tough time drawing an economic distinction between a zero yielding perpetual bond and a regular bank note. In addition, non-marketability would serve to increase the perceived permanence of the accompanying monetary injection because the bond cannot be resold back in the secondary market as is possible under QE[8]. Could it be that the design is such as to help circumvent the legal prohibition on the BoJ directly underwriting government debt?

Outright monetary financing (OMF), which the introduction of a zero-yielding perpetual government bond in Japan would facilitate, is widely considered effective because it would strongly underline the commitment of Japanese policymakers to reflate the moribund economy and remove any concerns over the size of the monetary operation (the government can just keep issuing the bond to satisfy the demands of the stimulus programme). Together, this should have a profound effect on public attitudes to inflation[9]. And, as we noted in a recent post[10], also realized inflation because

“if the past several years have taught us anything, it is that inflation is not simply a “monetary phenomenon” – it is also a psychological phenomenon”

There are, of course, many objections to OMF including the erosion of central bank independence and a relaxing of the budgetary constrain of politicians which encourages prudent fiscal policymaking.

However, the former is really a vacuous argument because as history clears demonstrates central bank independence is in the gift of the governing power – for example, the BoE was nationalized in 1946 and only had its independence returned in 1997! The latter objection is more problematic, but as mentioned previously, the existing size of the government debt stock means fiscal consolidation alone will be insufficient.

Given present sentiment levels, it is clear the crowd is not anticipating such an overtly aggressive policy change soon. This may well be right, but given how hard Kuroda has tried to achieve (and failed) to hit his 2% target, and given the clear unsustainability of Japan’s fiscal position, we are fast approaching the time when this last-resort policy option is all that is left.

Regards market impacts from such a policy leap (Abenomics on Steroids), it would have an extremely bullish effect on Japanese equity markets – in fact on any nominally priced asset for its perceived inflation protection – while putting the JPY under considerable pressure to depreciate (arguably the most reflating element of the first wave of Abenomics). As can be seen in the exhibit below, neither of these market themes appear present judging from the latest sentiment reads; further confirmation that the crowd is not expecting too much from the BoJ this month.

Exhibit 6. Nikkei & JPY Sentiment



Having contemplated this scenario for many years we consider the implications for JGBs to be minimal. This may surprise a great many investors because a surge in private sector inflation expectations triggered by a more radical easing programme like OMF should generate upward pressure on longer-term nominal interest rates. However, as higher (nominal but especially real) interest rates would short-circuit the stimulative effect it would make sense to sever this link completely; something that could be achieved via a bond yield cap (an unconventional monetary policy option that has been used before – see former governor Bernanke’s comments in a recent blog post [11]).

Very likely some form of bond market wobble would have to occur to galvanize support for such a radical policy departure but maybe the recent increased volatility in bond markets is the beginning of it[12].

In terms of the broader economic and financial implications, a rising Japanese stock market stands to be positive for global growth to the extent that it bolsters domestic demand in Japan, and hence would be welcomed by the other leading world economies.

However, a strong JPY depreciation would be viewed with much more concern given the growth-challenged nature of the world economy[13] and the size of the Japanese export machine. Certainly, the implied appreciation of the other major currencies would stop any Fed rate hiking cycle (even one as slow as the present one) dead in its tracks and likely be met with more central bank accommodation globally.

As we said at the outset, that’s why we consider the BoJ to be the world’s most important central bank.


 *Sentiment Analytics are based on MarketPsych indices. 


[1] See: While we agree on this point, we do not hold with the author’s same view on the topic that is the main focus of his speech as will become evident in the remainder of the note.

[2] The phrase “balance sheet recession” was widely used during the Great Recession. Remarkably, despite all the talk of deleveraging – a pseudonym for balance sheet recession – over recent years there has been very little of it when public and private debt levels are aggregated together. In fact, as Mckinsey pointed in in their comprehensive study of debt and deleveraging published last year, on a global basis debt has risen by a further USD 57tr since the start of the Great Recession (an increase of roughly 17 percentage points of nominal GDP), with no major economy having lowered its debt load (see: All that has happened is that the public-private mix has altered slightly (household and financial sector debt growth has slowed while government debt growth has accelerated).

[3] A phrase we first used in a post previewing the BoJ’s January policy meeting – see:

[4] There has been some suggestion that the purchases of JGBs by the BoJ could be written off. This is predicted on the basis that from a consolidated public sector balance sheet perspective the asset and liabilities net off. Such arguments show a distinct lack of economic understanding. JGB’s purchased by the BoJ form an asset on the central bank’s balance sheet such that if they are written off there must be a corresponding decline in the liability side of the BoJ’s balance sheet. This would require either the central bank writes down its capital (which is a drop in the ocean at JPY 7.6tr; hardly conducive to fostering perceptions of financial stability) or it will have to lower currency-in-circulation and/or current deposits held by commercial banks. Both of these are assets for the private sector and hence it would be (counterproductively) deflationary. NB: There is no theoretical obstacle to central banks having negative equity, but that just makes the financial stability objection ever more pertinent.

[5] A sentence we never thought we would write.

[6] In addition to corporate bonds, it owns stocks, equity ETFs and REITs.

[7] It coincides with the next FOMC meeting.

[8] The permanence of the operation is a key differentiator between QE and outright monetary financing (aka helicopter money); something that is very often overlooked, or at least downplayed.

[9] In the event that OMF is introduced in Japan our inflation outlook sentiment indicator would be a very useful tool to monitor its effectiveness because unlike conventional surveys the sentiment data are available daily and unlike market-based break-even rates they go beyond just the expectations of financial market participants.

[10] See:

[11] See:

[12] We first outlined this idea in a BSEC research note published in December 2014. This note is available to Amareos subscribers on request.

[13] Such concerns mean that BoJ purchases of foreign government debt is also a non-starter.

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