Bank of Japan Policy is Doomed to Failure

The Bank of Japan (BOJ), Japan's central bank, bowed to government pressure this week by adopting a 2% inflation target and accepting responsibility for achieving that goal "as early as possible."

The BOJ announced today (Tuesday) that it will begin a program of "unlimited easing" beginning in January 2014 following the end of the central bank's current asset-purchasing program in December.

In a statement announcing the results of Tuesday's Monetary Policy Committee meeting, the Bank of Japan said it anticipates purchasing 10 trillion yen in Treasury notes and 3 trillion yen in Japanese government bonds (JGBs) each month beginning in January 2014.

The statement also indicated the central bank's balance sheet will expand by about 10 trillion yen by the end of 2014 as a result of the purchases. No further expansion of the BOJ balance sheet is anticipated thereafter.

What the Bank of Japan Policy Means

What this means is that the Bank of Japan is not reinvesting any of the funds it received from the government for maturing Treasury notes and JGBs.

For central banks, the whole point of purchasing assets is to expand the central bank's balance sheet to increase the amount of money in the economy.

Sure, the Bank of Japan is going to buy 120 trillion yen in Treasury notes and 36 trillion yen in JGBs through the unlimited asset-purchasing program in 2014. But if the bank does not reinvest the funds it gets from the Ministry of Finance as the notes and bonds in its portfolio mature, the impact on the BOJ's balance sheet is minimal.

Treasury notes by definition have a maturity of less than one year and, so far, the BOJ will not purchase JGBs with a duration of more than three years for the asset-purchase program.

From a central bank balance sheet perspective, after three years it's like it never even happened.

To put it another way, unless the Bank of Japan continues to replenish its asset purchases, its balance sheet will shrink for three years after the asset-purchasing program is completed - an automatic tightening of monetary policy.

How Markets Reacted to BOJ Policy

Markets were disappointed with the result of today's BOJ Monetary Policy Committee meeting - but, to be fair, markets had a very unrealistic view of what could be accomplished.

Some analysts were disappointed that the vote to adopt the 2% inflation target was not unanimous (two board members dissented). Others were upset that there was no time limit set for achieving the 2% inflation target. Still others thought the central bank might announce either purchases of foreign currency-denominated bonds or some form of intervention in the currency markets.

Foreign observers also seem to have misinterpreted the phrase "unlimited easing," which gave them a false impression of what the BOJ had in mind. By "unlimited," the bank meant unlimited time, not unlimited amount. The only thing that has changed is that there is no time limit on asset purchases, whereas, under the old program, both amounts and time limits were fixed.

Frankly, this was a classic move to "buy on the rumor, sell on the news" in Japanese equities, bonds and in the currency market, all of which had been overextended in anticipation of today's meeting.

Japanese shares finished the day marginally lower, the yen strengthened against the U.S. dollar and the euro and JGB yields fell as traders covered shorts.

Now What?

In the end, today's announcement by the Bank of Japan is likely to accomplish nothing. The central bank did bow to political pressure and, as a result, it now owns the 2% inflation target along with the Abe government.

While today's measure will add some money to the Japanese economy beginning in 2014, it does nothing to address the real problem - no demand for funds.

Back in the 1990s, during the first round of quantitative easing, the Bank of Japan used to complain that no one wanted to take advantage of the extra liquidity being pumped into the system.

"Every day we set the table for eight, but only two show up," a central banker said.

The underlying issue is zero interest rates. Although there is unlimited demand for free money, there isn't an unlimited supply. Until banks and investors get compensated for the risks they take, they will be unwilling to lend money.

The BOJ floods banks with money but the banks can't charge enough to cover the risk of lending it out so nothing happens.

Since today's decisions do not impact the demand side of the equation, the Bank of Japan's "bold" moves are doomed to failure.

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