Monetary Policies in Japan, the United States, and Europe: Difference in the timing of policy change is a destabilizing factor

Faculty Fellow, RIETI

At the Group of Eight (G8) Summit held in Northern Ireland of the United Kingdom on June 17, 2013, global economic issues were discussed. Meanwhile, the Federal Open Market Committee (FOMC) held on June 18-19, 2013 attracted global attention, as the future direction of the monetary policy in the United States, which will have a significant impact on the entire world economy, was on the agenda.

Looking at the current world economy from a bird's-eye perspective, different economies are heading in different directions, as recoveries and downturns progress simultaneously. The U.S. economy, the epicenter of the global financial crisis, is showing signs of a gradual recovery, due to its aggressive monetary policies via quantitative easing. In the European economy, where many banks were directly affected by the global financial crisis, the sovereign debt crisis has finally come to a temporary lull.

Meanwhile, in Japan, which experienced the lost two decades although managing to avoid a significant direct hit from the global financial crisis, "Abenomics," the economic policy of the Shinzo Abe administration that seeks to end deflation, has begun. Stock prices have been rising and the yen has been depreciating, driven by expectations of the policy's effects. Although the economies of emerging markets such as the BRICs (Brazil, Russia, India and China) were expected to contribute to a rebound from the worldwide recession in the wake of the global financial crisis, their economic growth is decelerating now, almost five years after the bankruptcy of Lehman Brothers.

Amid the progress of financial globalization, the central banks of Japan, the United States, and Europe have adopted aggressive unconventional monetary policy known as quantitative easing in a bid to combat deflation, the global financial crisis, and the sovereign debt crisis, respectively. As a result, an overflow of money is sloshing around the world and is gushing across borders in pursuit of returns.

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Money running through the world economy does not flow consistently in one direction but instead moves chaotically, as the economies of countries go in different directions, which change at every moment. In particular, differences in the timing of monetary policy changes in Japan, the United States, and Europe have caused significant changes in the flow of funds through fluctuations in interest rate differentials. As a result, volatility (short-term fluctuations) in interest rates, stock prices, and exchange rates of countries has increased, and medium-term misalignments among currencies have arisen.

In July 2008, just before the outbreak of the global financial crisis, the exchange rate of the euro against the U.S. dollar reached a record high (1 euro=$1.60). One of the reasons for this was the difference in the timing for changing the monetary policy between the Federal Reserve Board (FRB) and the European Central Bank (ECB). To deal with the subprime mortgage problem (mortgage loans to individuals with low creditworthiness), the FRB immediately shifted to monetary easing in August 2007 when BNP Paribas Bank froze funds. On the other hand, the ECB, which was obsessed with controlling inflation until September 2008 when Lehman Brothers actually collapsed, was slow to adopt monetary easing, even though the subprime loan problem had a direct impact on financial institutions in Europe.

The figure shows movements in the short-term interest rate differential between the euro and the dollar (the value obtained by subtracting the federal funds (FF) rate in the United States from the European Inter-Bank Offered Rate (EURIBOR)), in comparison to the dollar-euro exchange rate. This interest rate differential was negative but began contracting in the second half of 2006 and turned positive in 2008. Reflecting this movement, the euro continued to appreciate until the middle of 2008. The fact that the euro continued to appreciate even though financial institutions in Europe were directly influenced by the global financial crisis was nothing less than a euro bubble, which had no connection with economic fundamentals.

Figure: The short-term interest rate differential between the euro and the dollar and the dollar-euro exchange rateFigure: The short-term interest rate differential between the euro and the dollar and the dollar-euro exchange rate

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The same thing is also evident in the misalignment of the yen, which appreciated excessively from 2008 because the Bank of Japan was slow to adopt "bold" monetary easing as a measure against deflation, including an inflation target, while the FRB was quick to shift its monetary policy to aggressive quantitative easing. The difference in the timing of the change in monetary policy caused violent fluctuations in exchange rates, and this misalignment has been working as a destabilizing factor for the world economy.

Henceforth, central banks in Japan, the United States, and Europe will be looking at how long to maintain their quantitative easing monetary policies and when to initiate an exit policy—something that is already being discussed in the United States—with their eyes on their respective economic conditions. However, it is inevitable that the timing of the policy change will differ among them. Given that it is highly probable that the timing of the change in monetary policy, or the exit from quantitative easing, will differ, and therefore that funds will repeatedly flow into and out of these three economies, very violent fluctuations in interest rates and stock prices as well as misalignments among currencies are likely to occur.

A factor that will further aggravate these fluctuations and misalignments is the expectations of market participants. Once the monetary policy has actually changed interest rate differentials, and exchange rates or stock prices have shifted, it will already be too late for them to speculate. They will not obtain gains unless they act before the financial variables begin to change. Therefore, they need to anticipate a change in monetary policy beforehand and look for "news," or new relevant information, and make a prediction based upon it.

Whenever "news" on changes in the monetary policy of a central bank emerges, expectations of market participants shift. Speculation based on these expectations will further increase fluctuations in interest rates, exchange rates, and stock prices. The fact that expectations of market participants have an impact on financial variables, like a self-fulfilling prophesy, could also give rise to a bubble.

As the expectations of market participants fitted the vector of "bold monetary policy" from the Bank of Japan after the inauguration of the Abe administration, the weak yen and rising stock prices became a reality due to market behaviors based on the sense of expectation. Paul Krugman, a professor at Princeton University, called this phenomenon the "honeymoon effect." Viewing it from the opposite side, however, unless the expectation that Japan will break away from deflation is actually realized, the sense of expectation will be disappointed, and the backlash may then swing largely in the opposition direction.

The difference in the timing of the change in monetary policy in Japan, the United States, and Europe and expectations thereof could have an impact on not only the exchange rates of their respective currencies, but also on the economies of emerging markets such as the BRICs.

One of the causes of the currency crisis in Mexico in 1994 was the change in monetary policy in the neighboring United States, as the U.S. economy moved from recession to boom. The FRB sharply raised the FF rate, which was below 3% in December 1992 while the economy was in recession, to the 5% level in December 1994 in step with the economic recovery. This prompted a massive shift of funds, which had flowed into Mexico from the United States from 1992 to 1993, back to the United States from Mexico from 1994. As a result, the Mexican peso crashed.

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In emerging market countries such as BRICs, the economy overheated as a massive volume of funds flowed out from Japan, United States, and Europe due to their respective quantitative easing policy and flowed into these countries. However, a flow of funds back and a bursting of bubbles, and moreover a currency crisis, could occur if interest rates begin to rise in Japan, United States, or Europe due to a monetary shift to an exit policy.

A factor that could further aggravate these phenomena is a structural fall in the economic growth rate in emerging markets. Developing countries always run the risk of falling into the "middle-income country trap," in which once a certain degree of economic growth is achieved, they cannot advance further toward becoming high-income countries due to the loss of their international competitiveness as a result of rising wages.

In emerging countries that were unable to use an influx of funds to improve their productivity at a time of low interest rates in Japan, the United States, and Europe, there are concerns that a serious outflow of money and a subsequent bursting of a bubble and currency crisis may occur in association with the exit policies of the central banks in the three economies. More than ever, it is required for these central banks to have a delicate management of monetary policy through policy dialogues and international coordination.

>> Original text in Japanese

* Translated by RIETI.

June 18, 2013 Nihon Keizai Shimbun

July 24, 2013