The BOJ’s recent decision is likely to end up being far more important than anything the Fed does or does not do today. But as of now it raises more questions than answers:
1. The BOJ announced it would cap 10-year bond yields at 0%, and also that it would attempt to overshoot its 2% inflation target.
2. The BOJ did not announce lower IOR or more QE.
Today’s market reaction is hard for me to gauge. The initial reaction was clearly positive, as stocks rose nearly 2%, and the yen fell by almost 1%. Later, however, the yen more than regained the ground it lost. That doesn’t mean the BOJ action had no impact, just that whatever impact it had was at most slightly more than markets anticipated.
The overshoot promise could be viewed as either Krugman’s “promise to be irresponsible”, or as a baby step toward level targeting. Martin Sandhu gives a third interpretation—a signal that the target really is symmetrical, despite all the talk about a de facto 2% inflation ceiling in many countries. There’s no reason that all three interpretations could not be a little bit true—after all, central bank policy is made by committees.
I vaguely recall Bernanke suggesting something like a long term interest rate peg—can anyone confirm? I have mixed feelings about this idea. On the one hand, I like moving monetary policy away from a QE/negative IOR approach, and toward a price peg approach. But I view interest rates as almost the worst price to peg, for standard NeoFisherian reasons. Are low long-term rates easy money, or a sign that money remains tight? That’s not at all clear.
Although I am disappointed by the specific steps taken today, these actions do make me more optimistic in one sense. The BOJ has shown that it’s still willing to experiment, and that it still wants to raise inflation. Here’s an analogy. When the Fed first engaged in forward guidance, they did so in a very ineffective manner—low rates for X number of years. This was criticized as being rather ambiguous—in much the same way the BOJ’s 10-year bond yield cap is ambiguous. So the next step in forward guidance was to make the interest rate commitment conditional on the economy, a major improvement. Perhaps the BOJ’s next step will be to switch to price level target, to make the size of the inflation overshoot more concrete. Or maybe instead of capping 10-year bond yields, they’ll peg something more unambiguous, such as the yen against a basket of currencies. If that’s too controversial (and it probably is) then peg the yen against a CPI futures contract.
The danger is that this specific move won’t work, and the backlash will prevent the BOJ of moving further down the road in the future. Maybe that’s why the yen reversed course a few hours later.
PS. It just occurred to me that the 10-year bond yield cap could be viewed as a sort of commitment to enact a policy expected to lead the yen to appreciate by at least 1.68%/year against the dollar (for standard interest parity reasons). That’s a non-NeoFisherian way of explaining why I’m skeptical. In the long run, this bond yield cap means that Japanese inflation is likely to be 1.68% lower than US inflation. They really needed to do the opposite of what the Swiss did early last year—they should have sharply depreciated the yen, and simultaneously raised interest rates.
PPS. Kudos to Krugman. Ideas that start out seeming very “ivory tower”, such as promising to be irresponsible, can end up being enacted, at least in part. Unfortunately, Krugman first proposed that idea under the (quite reasonable) assumption that liquidity traps would be temporary. The markets don’t seem to believe that any longer, at least with respect to Japan.