The Unraveling of the Central Bank ‘Put’: Bank of Japan Abandons 1% Cap on Bond Yields

2023-11-01 13:33:40

By abandoning its 1% cap on 10-year bond yields, the Bank of Japan has taken a big step toward dismantling a widely held assumption at the heart of G10 monetary policy for decades – the idea of a “put” from the central bank.

Justified or not, the idea has stuck with investors since the days of former Fed Chairman Alan Greenspan that the Federal Reserve – and later other central banks – would always eventually ease credit to support faltering asset markets when falling prices threatened to snowball.

This idea was perhaps more mythical, as William Poole, former president of the St. Louis Fed, pointed out in 2007. The line between preserving financial stability and supporting asset markets has become blurred. considerably faded in the following years, which is understandable since the great financial crisis.

But for the most part, since the late 1980s, when Greenspan became Fed chairman, central banks have been mostly equipped to combat the risk of deflation rather than inflation — and institutions such as the Bank of Japan and the Swiss National Bank were at the heart of this battle.

Many economists argue that that world is now over – as even Japan now struggles with above-target inflation – and that the idea that central banks will automatically ease policy to support financial markets seems somewhat fanciful.

Markets failed to realize that “central bank put” was a luxury product, which only really existed when inflation was under control, below target, and risks were at a premium. decline,” says Steven Englander, head of global G10 currency research at Standard Chartered in New York.

“It is fair to say that all those policies which aimed to strengthen the asset market by injecting liquidity into the market have been withdrawn.

The idea of ​​central banks coming to the rescue of investors by lowering interest rates in times of crisis took root early in Greenspan’s tenure as head of the Fed. Policymakers began to place more emphasis on the wealth effects of stock prices on consumption and, therefore, economic growth.

A March 2020 National Bureau of Economic Research working paper noted: “The statistical fact is that since the mid-1990s the Fed has tended to cut rates by regarding 1.2 percentage points on average in the year following a 10% decline in the stock market.”

Additionally, changes in interest rates are asymmetric: Fed rate hikes that follow stock market rallies are generally muted relative to initial cuts.

FINANCIAL STABILITY

When near-zero interest rate policies (ZIRP) emerged following 2008, the easier transmission of money – and the notion of central bank “put” – extended to the purchase of government bonds or exchange rates, as in the case of Switzerland.

For years, the SNB fought once morest market pressure to push up the Swiss franc, capping it at 1.20 per euro in September 2011 until January 2015, when it simply retreated, triggering intense volatility and a rapid revaluation of 30%.

This was an explicit and open policy aimed at keeping the currency at a fixed level and flooding the Swiss economy and markets with oceans of liquidity, but it was still essentially an implementation of the central bank.

Since the post-COVID-19 inflationary surge, which reached 40-year highs in many developed economies, policymakers have moved further away from these extremes, tightening policy with unprecedented rate hikes, by reducing their balance sheets, or both at the same time.

With its history of deflation, Japan has always been the last to move. Public debt is the highest in the world, at more than 250% of GDP, and the BOJ owns regarding half of the entire government bond market.

Although it kept the benchmark policy rate at -0.10% on Tuesday, the importance of the downgrade in the 1% yield on Japanese 10-year bonds should not be underestimated, from a absolute ceiling at a “reference” rate.

The cap was set only three months ago, and the speed with which it was abandoned suggests that the BOJ, under Governor Kazuo Ueda, is serious. Given that the BOJ is now forecasting inflation well above its 2% target for next year, might it shift gears and perhaps even raise rates in the coming months?

Maybe it’s too much, too soon. Highlighting the BOJ’s difficulty in managing its exit in a jagged rather than immediate fashion, the BOJ intervened in the bond market once more on Wednesday.

Policymakers are aware of the damage that rapidly rising borrowing costs might do to countless Japanese banks, financial firms and businesses that have gorged on free and easy money for decades – so-called “zombie companies”.

As Marc Chandler of Bannockburn Global Forex points out, it is financial stability that is ultimately – and rightly so – at the heart of so-called central bank “put”.

“There is a perception or myth that has been built around the central bank put option. It does not really exist, not in relation to prices or market levels. It is poorly understood. It’s regarding financial instability,” says Chandler.

(The opinions expressed here are those of the author, columnist for Archyde.com)

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