They Did What?

Dave Forest
Pierce Points
Oct 6, 2010

I know I've been heavy on the macroeconomics lately. But one global financial development today demands a comment.

Overnight, the Bank of Japan announced unprecedented monetary policy. The Japanese are going "all-in" on economic stimulus.

Since the financial crisis, "monetary easing" has been a buzzword globally. For many governments, such policy has consisted of central banks buying government bonds. In essence, the banks pump new money into government coffers and the government turns around and pumps it onto the street. The hope being this infusion of cash will lift the economy.

Japan is an old hand at this. In fact, the Bank of Japan (BOJ) was buying government bonds long before it was fashion to do so in other developed nations. To the point where the BOJ today holds 55 trillion yen ($660 billion) worth of government bonds.

But apparently the Japanese aren't satisfied.

Today, the Bank of Japan announced it is moving to a program of "comprehensive monetary easing".

As part of the program, the Bank will attempt to drive overnight interest rates to "virtually zero". This shouldn't be a problem, as Japanese interest rates were almost there anyway.

Here's where it gets sensational. Low interest rates aren't enough for the BOJ. To allow further easing, the Bank is implementing an "asset purchase program" designed to pump more yen into the financial system.

The interesting thing is what assets the bank intends to purchase.

Of course, there's the usual suspects. Under the program, some 3.5 trillion yen ($40 billion) will be devoted to purchasing government bonds and treasury discount bills.

But that's not all. A further 1 trillion yen ($12 billion) will be earmarked for buying bonds from Japanese corporations, as well as purchasing exchange-traded funds (ETFs) and real estate investment trusts (REITs).

It's a bold move for a central bank to directly buy corporate bonds. Essentially, this will raise bond prices and lower yields to the point where such instruments may not be attractive to regular investors. If you're taking on the risks of investing in a corporation, you want to be compensated with higher yields. Direct government buying could make that impossible.

The real kicker is direct central bank buying of ETFs and REITs. As far as I'm aware, this has never happened on planet Earth (not in such a direct manner, anyway). The BOJ is buying directly into the stock market.

This again will reduce the potential returns on such investments. Making it harder for average investors to turn a profit. Even the Bank itself acknowledges this is a radical departure. A quote from today's public note: "It is an extraordinary measure for a central bank, particularly the purchase of financial assets to encourage the decline in risk premiums."

So, why is this happening?

Throughout today's official release, the BOJ talks about the need to decrease longer-term interest rates and risk premiums. Money-wise, this would have two effects. First, lower interest rates make it more likely (theoretically) that consumers and businesses will borrow money. The hope is they will then spend it, stimulating the economy.

(In practice, this has not worked out. Credit lines extended to Japanese businesses have been falling for the past two years, despite ultra-low rates. Same in the U.S., where outstanding bank loans to consumers and businesses have been declining steadily, even with interest rates near record lows.)

The other hope is that direct government buying of financial assets will make investment unprofitable. If yields on bonds, stocks and other financial instruments tank, people aren't going to park money in these things. Instead, they'll spend.

(Again, this is somewhat dubious. The Japanese have a history of saving their money, despite ridiculously low interest rates on saving accounts. That does appear to be changing the last few years however, so maybe the BOJ plan has some hope.)

Although unmentioned in today's release, this easing policy is also likely targeting the yen. The yen has gained 13% in value since May. And a strong currency is a big concern for an exporting nation like Japan.

By cramming more yen into the economy, the BOJ may be trying to debase the currency. We'll see if this follows. After today's announcement, the yen fell briefly against the dollar but has since rallied to stand higher than before than news.

I've mentioned a few times that Japan may be the site of the next big economic dislocation. The nation is now venturing into uncharted monetary waters. Beware the rocks.

Here's to the difficulties of easy money.

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Oct 6, 2010
Dave Forest
email: dforest@piercepoints.com

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