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For central banks, no easy solution

Federal Reserve Board Chair Janet Yellen takes a reporter's question during a news conference on Sept. 21 in Washington.

After the Bank of Japan and U.S. Federal Reserve meetings this week,  it is clear their positions could not be more different. While the BOJ is struggling to ease monetary policy, the Fed is struggling to tighten, or more accurately, to reduce monetary accommodation. In both cases, though, what we can read between the lines is a growing concern about the ineffectiveness of monetary policy alone in addressing complex economic circumstances.

The Fed's decision to leave interest rates unchanged again is, in many ways, more straightforward than the BOJ's announcement. The split vote at the Fed, at 7-3 for no change, reveals an interesting picture of division between the rotating Fed presidents and fixed-term governors on the Federal Open Market Committee. Fed chair Janet Yellen may have to work harder to overcome such division for a stronger consensus in the future.

Yet, there were even greater nuances in the Fed's decision. The official announcement noted that the "case for a rise in the Federal Funds rate had strengthened," but that the committee would nevertheless wait for additional evidence on the economy before agreeing to raise rates. Since the next Fed meeting is just before the presidential election, this means no change in policy is likely until December at the earliest.

Bank of Japan Gov. Haruhiko Kuroda speaks to the press at the central bank headquarters in Tokyo on Sept. 21.

Two questions then arise. First, what evidence is the Fed waiting for before raising rates? Second, how serious is the Fed anyway, bearing in mind that its principal forecasts for unemployment and inflation out to 2019 and beyond are essentially unchanged?

The only changes were to economic growth forecasts, lowered by 0.2 percentage points to 1.8% for 2016 and in the longer term. Yet the forecast for interest rates was lowered from 0.9% to 0.6% this year, 1.6% to 1.1% in 2017, and 3.3% to 1.9% in 2018. This does not speak to a Fed that thinks things are going back to "normal" any time soon.

What the Fed is waiting for is confirmation that the labor market in particular and the wider economy are sufficiently robust to weather a further rise in interest rates in the face of uncertainties in the global system, specifically in Europe and potentially in China. The latter two issues seem to have become less urgent, at least for now, and so should not restrain the FOMC for the foreseeable future.

On the face of it, the Fed can take some comfort from decent job gains, slowly rising participation rates and consumer spending. But it will be wary of disappointing capital investment trends and mindful of what has been a major inventory correction over the last year which has cut gross domestic product growth significantly.

If inventory problems are being resolved, capital spending could be revived after the U.S. presidential elections. If the new administration embraces higher investment spending, the path to higher interest rates may become clearer. But how markets react to the election and what a Hillary Clinton or a Donald Trump presidency portends for the economy will become crucial soon enough. Right now, there is no discounting in the markets for a Trump White House.

Just as hard

The BOJ does not have to contend with the political machinations surrounding the Fed. But its job is no easier, an observation that was clear in the announcements made this week. The most significant was that the BOJ would expand the monetary base sufficiently, in other words print money, until inflation rose above 2% on a sustainable basis; and that it would target a 0% yield for 10-year Japanese government bonds, while continuing to buy 80 trillion yen ($787.6 million) of bonds per year. 

Monetary obsessives argue that the monetary base expansion finally proves that the BOJ will not back away from its commitments and therefore, inflation expectations will rise. This seems rather optimistic, considering that the monetary base has risen threefold since Abenomics started in December 2012 with its focus on fiscal stimulus, monetary easing and structural reforms. And yet, Japan still has not distanced itself from deflation. 

It is also unclear what the BOJ is now targeting. By saying it will buy any amount of 10-year JGBs at zero yield, it has adopted a price target for bonds, as the yield and price of a bond are inversely related. But buying 80 trillion yen of bonds a year is a quantity target, under which the price or yield could vary. One of these targets is going to disappear before long, because the BOJ cannot target price and quantity simultaneously.

In fact, the BOJ now has six targets, just to make things really confusing. A price and a quantity target for JGBs, negative interest rates now at -0.1%, the Japanese yen as a transmission mechanism to inflation, 2% or more inflation, and a steeper yield curve (or higher interest rates for longer dated bonds). The last of these derives from the attempt to keep 10-year yields at zero, and allow longer dated JGB yields to be higher.

This could help the profitability of banks and insurance companies struggling with a negative rate environment, but we should remember that the fundamentals are the really important driver here: Unless the BOJ and/or the government can engineer a sustainable rise in real GDP growth and inflation, investors will simply buy longer-dated bonds again, and the yield curve will get flatter -- quite the opposite of what the BOJ intends. 

It would be far simpler, and more transparent if the authorities in Japan were to admit that unusual monetary policies, as currently constituted, had reached the limit of their effectiveness given the demographic and structural conditions that now prevail. This should then lead to a discussion as to how the BOJ and the government might work together to help policy gain greater traction, essentially debate the fiscal nature of what people call "helicopter money."

Under this arrangement, the BOJ would buy bonds directly from the government to help finance spending or tax reductions. In effect, the BOJ is already doing a form of monetary financing by keeping the 10-year JGB yield at zero indefinitely, and so we might argue that the authorities should go all the way and do monetary financing properly, openly, and with constraints that should be spelled out.

The one thing that both the Fed and the BOJ have in common is their inability alone to create the kind of inflation that would allow them to back away from overtly easy monetary accommodation. This applies equally to the European Central Bank, the Bank of England and other central banks.

In some ways, monetary accommodation is actually exacerbating the problems the central banks are trying to address. For example, many people, especially senior citizens with inadequate retirement funds, are driven to save more, while zombie companies are kept alive perpetuating a misallocation of capital, and retarding new investment opportunities. The lesson to draw from this week's meetings is that central banks are not equipped on their own to deliver the economic changes we crave.

George Magnus is an economist and author of publications including: "Uprising: Will Emerging Markets Shape or Shake the World Economy?"

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