May 14, 2017 3:00 pm JST

Central bankers face a long drive before reaching their exit

The extraordinary measures they have taken will be difficult to reverse

AKIO FUJII, Nikkei senior editorial writer

© Reuters

TOKYO -- On May 8, central bank executives from across the globe gathered in a hotel here. The meeting, called by the Bank for International Settlements, was a rarity in that it was held in a city other than Basel, Switzerland, where the bank is based.

Many participants were relieved by news that came earlier that day -- centrist Emmanuel Macron had won the French presidential election. The result boosted hopes that the global wave of populism -- first apparent last year when U.K. voters opted to leave the European Union -- can be moderated.

But it is too early for unbridled optimism. After nearly a decade, central bankers are still struggling to contain widespread financial turmoil that has entirely changed how the world looks.

It has been 10 years since the subprime mortgage fiasco first emerged in the U.S. In 2007, many holders of these mortgages began defaulting. Wall Street had gorged on the collateralized debt obligations that pooled these easy-to-get mortgages together, and the increasing default rate set off a crisis that unfolded in four stages.

  • The impact of subprime mortgage defaults quickly spread throughout the U.S. financial sector. Within a year, Lehman Brothers and other big Wall Street marques had disappeared. The financial paralysis that ensued spread to global financial markets, too.
  • The global circulation of funds all but seized up, throwing economies around the world into turmoil. Officials from Japan, the U.S., Europe and emerging economies got together to discuss how the financial system could be resuscitated and the global economy reinflated.
  • As economies slumped, tax revenues fell. Government spending measures to revitalize economies swelled debt levels. This heightened the crises in Greece and certain other European nations. U.S. Treasurys were downgraded. In the end, governments had to both clean up the mess and pay up.
  • Negative and visible consequences -- prolonged economic slumps, widening wealth gaps and tax revenues being redirected to rescue banks -- began amplifying people's anger against current political systems. Populism, isolationism and anti-globalism emerged. Brexit and Trump happened.

While governments were paralyzed and dysfunctional, central banks had no choice but to take up the fight on their own. They squeezed out measures and pulled monetary easing levers marked "The Last Option." This put them on spending sprees; they bought up government and corporate bonds and later introduced negative interest rates.

While taking this road has begun to show positive outcomes, it will also require massive repair jobs someday.

Eventually, governments will have to begin unloading the massive amount of financial assets they have acquired. The Federal Reserve might begin shrinking it's balance sheet within this year. Also, there are rumors that the European Central Bank might next year start scaling back its quantitative monetary easing measures.

The same cannot be said of the Bank of Japan, which is not ready to move on. The central bank has so far failed to boost the economy and meet its inflation target of annual 2% price increases. Until it achieves this goal, the BOJ will not consider reducing its extraordinary easing measures.

According to Hajime Takata, chief economist at Mizuho Research Institute, there were five global monetary-tightening phases, beginning in the 1970s, before the global financial crisis emerged. Each time, the U.S. and European central banks acted first to raise rates. Each time, the BOJ eventually followed.

It was often the case that soon after the BOJ moved to hike its policy rate, the world economy would enter a downward trend, and the Fed would turn to rate cuts again.

However, the BOJ jinx likely will not kick in this time, Takata said. The BOJ, the economist implied, will not even have the chance to raise rates this time.

Back to normal

Simply put, when central bankers stepped into financial markets as buyers of last resort, they ended up hampering healthy competition. It used to be believed that long-term interest rates were uncontrollable. But when central bankers kicked into action nearly 10 years ago, all the asset buying of government bonds they did kept long-term rates low. The BOJ saw this and even tried to control the stock and property markets by purchasing exchange traded funds and real estate investment trusts.

It is time, however, for central banks to allow the market mechanism to once again do its job. Yes, the large amount of assets that would be up for grabs again could cause volatility and even send shock waves around a world that has grown used to the not-so-invisible hand of central bankers.

As the BOJ already lags the Fed in letting go of that last-resort lever, what might happen?

Let's assume long-term interest rates were allowed to surge in the U.S. The trend could spill over into Japan. To stop any upward pressure on rates and to keep its target for the yield on 10-year Japanese government bonds around zero, the BOJ could be urged to continue buying JGBs.

If the BOJ were to manage to keep interest as low as it anticipates, the rate differential between between Japan and the U.S. would widen. This would likely strengthen the dollar against the yen, opening the door for U.S. politicians to criticize Japan for manipulating the exchange rate via monetary policy.

Central banks, especially the BOJ, are far from the offramp that will lead them away from financial market control. In fact, central banks, governments and big market players all have a hand on the wheel, and all three parties are properly motivated to keep steering straight ahead.

If they do not find that offramp, though, we all might pay the price -- a new round of financial turmoil.

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