Opponents of Abe-economics — a policy whose defining characteristic these days is ever more radical monetary experimentation and a creeping but serious deterioration in the public finances — are in despair.
Yet again, as in March 2015, the Japanese PM Abe has called a snap election (one year short of a full term with a campaign limited to 3 weeks), this time with the intention of crushing a potential leadership challenge within his party (the LDP) which incidentally could have brought a change in economic policy direction.
PM Abe took a gamble. The established opposition party to the LDP, the DPJ, is weak and indeed in meltdown. But the Party of Hope formed just in the last few weeks by popular governor Koike (the nationalist ex LDP defense minister, previously a television news anchor) could galvanize a protest vote. Opinion polls suggest now that the Abe’s LDP will obtain indeed a large majority in the Diet following the October 22 election.
Governor Koike has gained from the corruption scandals beleaguering the PM but she articulates no alternative to Abe-economics. In fact her party’s program supports continuation of the mega-money printing program
This time, like the last, the ostensible justification which PM Abe has advanced for a snap election is to win voter approval for his decision to over-ride already legislated fiscal discipline. In 2015 the election was called to postpone a looming increase in the consumption tax; this time it is to match that delayed tax increase (scheduled now for 2019) with a boost to social spending.
The fact that such a rolling back of fiscal tightening is indeed saleable to a doubting public fully aware of the weak public finances is due to long-term interest rate markets having ceased to exert any constraint. They have become dysfunctional in consequence of monetary radicalism — now extending to the Bank of Japan (since September 2016) pegging long term interest rates at zero.
Destroying Market Signals
How could there be such dysfunctionality?
After all, Paul Volcker said that he quickly learnt as Fed chief that markets are more powerful than the Fed. So how has Abe’s Bank of Japan been able to essentially shutter the signaling function of long-term rate markets?
There is no Abe black magic here. Rather, the non-conventional policy instruments which are now embedded in the 2-per-cent inflation targeting regime have been remarkably effective in paralyzing markets. Monetary policy has destroyed effectively the signals and more fundamentally the decentralized information gathering process about conditions of demand and supply for loan capital which would operate in a free market under a sound money regime.
Yes, the long-term US rate market still seems to have some signaling function — at least regarding the stage of the economic growth cycle. It is dubious, though, whether long-run inflation danger registers in any meaningful way.
The boldest Don Quixote would be cautious about leading a vigilante attack on complacency in the US long-term rate market. He would fear being run over by the next stampede of the bulls into the long-maturity Treasury market when the present episode of global asset price inflation enters its crash stage. Meanwhile, the desperate hunters for yield fleeing the negative rate income deserts in Europe and Japan have in many cases lost rationality. And the stories about these hunters excite many speculative traders around the world to bet on their continuing weighty presence.
What to Expect In the Future
Many investors suspect a new high-inflation era will arrive eventually. But they are in no hurry to make an early exit through the gates of the long-maturity US fixed rate market. Even when inflation heads higher, the Federal Reserve and other central banks will proceed glacially with official rate increases. They will cite forecasts of lower inflation ahead.
Policy normalization is not set to occur in the form of a sudden shrinking of the monetary base and a restoration of a free market in short and long-term rates. Until this returns to a normal proportion of the money supply and re-assumes zero interest bearing form there is absolutely no prospect of the Federal Reserve or any other central bank abandoning discretionary control of short-term rates where each 25bp move is Big News in favor of market determination.
Long-term Japanese government bonds, in contrast to Treasuries, have absolutely no attraction to global yield seekers — except sometimes as hedged into dollars to produce an attractive spread over Treasuries. The secret of the Abe government’s power to suppress the long-term rate at zero is having the Bank of Japan step up its purchases of long-maturity government bonds (JGBs) to such an extent as to induce some existing holders to sell. (In effect the BoJ is buying more bonds via money printing than are being issued to fund the current general government deficit). There is widespread reluctance, especially on the part of institutional holders, to shed JGBs on which they are still collecting coupons at significantly positive rates even though their price will fall in the approach to maturity.
True, global speculators could take a massive bear position. But shorting Japanese government bonds has the reputation for being the “widow’s trade.” Even so, It is not clear how at long-term rates of zero there is much anymore to lose. The fiscal arithmetic is daunting. A general government deficit now running at around 5% of GDP when the net total of government debt is at 135% and the gross total at 250% (two thirds of the difference being government loans of dubious worth) is daunting. If interest rates were to return to normal levels, the deficit together with servicing costs would balloon.
Some bond bulls may have convinced themselves that inflation in Japan will never rise from the present officially reported rate of under 1 % per annum — citing all the flawed forecasts in recent years. Yet basing inflation expectations in the long-run on past inflation behavior is a form of irrationality.
Yes, the natural rhythm of prices has been downwards due to globalization, especially economic integration of Japan and China, alongside the digital technology revolution. But at some stage those disinflation forces are set most likely to weaken . Whenever that happens there is every reason to believe that the monetary and political environment in Japan will not halt the rise of reported inflation. Abe’s tool of snap elections to crush a key and divided opposition has emerged as a key weakness in Japanese democracy.
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