April 11, 2013 7:14 pm

Markets Insight: Japan should heed lessons of Volcker’s war

The former Federal Reserve chairman knows well the limits of central bank powers

When Haruhiko Kuroda, the new governor of the Bank of Japan, announced a radical new form of quantitative easing this month, some pundits dubbed it his “Volcker” moment. No wonder.

Just over three decades ago, Paul Volcker, then the US Federal Reserve chairman, leapt into the history books with a bold gamble to squeeze inflation out of the American economy by jacking up interest rates to a peak of 21.5 per cent. Now Mr Kuroda is engaged in another dramatic move – albeit this time to banish deflation. And, as before, it is a move that carries economic and political risks of the sort that central banks usually hate; hence that “Volcker” tag.

But as investors reel in surprise, there is a certain irony here: Mr Volcker himself is far from thrilled about this month’s policy shift. Of course, he does not want to criticise Mr Kuroda or any of his colleagues directly; that would breach central bank etiquette. But this week I chaired a debate at New York University with the former Fed chairman, and he could not hide his profound unease. “Central banks are no longer [acting like] central banks,” he warned, amid a discussion about Japanese and American monetary policy. “I think it gets dangerous when they lose sight of the basic function of the central bank.”

The key issue concerns what this “function” should be. In recent years, it has generally been assumed that a central bank’s core mandate is to keep inflation low and growth on track (and, in the case of the US, to deliver low unemployment too). Mr Volcker disagrees. “The basic function of a central bank is to defend the value of the currency,” he insists, arguing that central banks function most effectively when they focus primarily, if not exclusively, on that aim.

In theory, that “value” function is not at odds with other goals, such as hitting an inflation target or boosting growth. But in the current world, since central banks are now unleashing unorthodox measures to achieve those alternative growth and inflation mandates, they are increasingly losing sight of the “value” function.

When central banks start gobbling up equities, long-term bonds or mortgage debt, for example, they risk damaging themselves and markets, Mr Volcker argues. “There are going to be big losses in central bank portfolios – you cannot assume that interest rates will remain low for ever ... the Federal Reserve [has now become] the world’s largest financial intermediary.”

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Then there is political risk: the more central banks embrace unorthodox measures, the more politicians, investors and voters alike expect them to deliver magic tricks. In particular, Mr Volcker hates the idea – now current in Japan – that central banks should deliberately stoke up inflation to boost growth. “The central bank is not an all-powerful tool,” Mr Volcker says. “Once you have the idea that a little bit of inflation is a good thing, it is very hard to get rid of it.”

Most investors – and some central bankers – will probably just shrug their shoulders; in today’s world, Mr Volcker is apt to sound like a cranky general obsessed with trying to fight the last war. After all, there is little sign of increased price pressure in the US, let alone Japan, or any dramatic loss of currency credibility. Inflation expectations in the 10-year US Treasuries market tumbled to 2.4 percentage points this week, the lowest level for three months, and roughly in line with their levels in the past three years.

And while a survey this week showed three-quarters of households in Japan now expect prices to rise, this follows several years of deflation. Indeed, the sense of stagnation is so ingrained in Japan that it is widely assumed nothing short of “shock and awe” will shift the mood. It is also assumed that if – or when – prices pick up again, the BoJ will be able to reverse course with relative ease. So, too, in the US, where this week’s release of the Fed minutes showed the Fed governors were actively discussing future exit strategies, and were hoping this would be smooth.

But even if this backdrop makes it politically easy for policy makers to brush off Mr Volcker’s words, sometimes it is useful to at least reflect on the last economic “war”. After all, the battle that Mr Volcker fought three decades ago has left him keenly aware of just how fragile confidence in central banks can be. It has also taught him how limited a central banker’s powers really are.

Ironically, that is not a lesson Mr Kuroda himself needs to relearn; in private, the new BoJ governor is keenly aware of those two points (not least because of the structural impediments in Japan, of the sort that my colleague Martin Wolf described this week). But those investors snapping up Japanese and US assets today with such glee should note Mr Volcker’s words, even – or especially – if they are too young to have witnessed that original “Volcker moment” with their own eyes.


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