From zero to hero

Compared with Ben Bernanke, the chairman of the Federal Reserve who recently cut interest rates by 125 basis points in eight swashbuckling days, Toshihiko Fukui might seem to have been leading a quiet life. Mr Fukui, whose term as Bank of Japan governor ends next month, has changed rates only twice in his five-year tenure: two rises totalling a measly 0.5 per cent.

But this modest headline number hides what has been a historic and controversial period for Japanese central banking. Under Mr Fukui, the bank ended its unprecedented experiment in ultra-loose, zero-interest-rate policy, designed to battle years of deflation, and returned to a conventional interest rate targeting regime. His successor, who should be nominated by the government this week, will inherit a bank that, however tentatively, has regained control over the normal levers of monetary policy.

To stave off a deflationary spiral and possible implosion of the financial sector, the BoJ had been hosing the markets with trillions of yen of liquidity and printing money to buy shares and asset-backed securities – hardly standard fare for a staid central bank. By March 2006, three years into his tenure, Mr Fukui declared victory over deflation and began to dismantle the super-loose “quantitative easing” policy. He then steered the bank’s board through two rate rises.

How the Bank of Japan performs matters not only for the world’s second-biggest economy. Japan’s transition from financial catastrophe to modest growth has been an important event for the global economy. Only a week ago, Hank Paulson, the US Treasury secretary, told the Group of Seven leading industrial nations, meeting in Tokyo, that Japan had graduated from being a drag on world growth to a net contributor.

The BoJ’s interest rates can also have a big impact on the carry trade, which has provided almost endless liquidity for investors wanting to borrow in cheap yen and invest in higher-yielding assets abroad. Years of zero Japanese interest rates may have thus contributed to the massive flows into risky global credit markets, some of which have now spectacularly crumpled.

As the bank starts to raise rates – narrowing the differential with other countries busily loosening monetary policy – that trade appears to have gone into reverse. So far, the unwinding has been fairly orderly, with the yen rising from about Y120 to the US dollar to about Y106 since last summer. But the potential for more dramatic swings persists.

Such international considerations have to be weighed against the bank’s primary concern of engineering Japanese price stability. Tighten too quickly, as some contend the BoJ has done, and Japan may underperform or even sink back into recession. Tighten too slowly and, in some experts’ opinion, the bank could be storing up inflationary trouble ahead.

Ben Eldred, an economist at Daiwa Securities who is more generous than some in his assessment of Mr Fukui’s performance, says people should recognise “the important role he played in nurturing the economic recovery and extricating Japan painlessly from quantitative easing”.

Yet Mr Fukui leaves office with that job only half done. At 0.5 per cent, rates are far below what he considers “normal” for an economy that has been growing at roughly 2 per cent for six straight years. Mr Fukui has made it clear he regards abnormally low rates as distorting and dangerous.

For some economists, such thinking has led Mr Fukui to jump the gun. Headline inflation may be rising but, stripped of energy costs, prices are still falling slightly even now. To these economists, Mr Fukui has defied the central banking rulebook by raising rates before deflation is decisively beaten.

How one assesses Mr Fukui’s performance depends on where one believes a central bank’s priorities should lie. For those who argue that a bank should be super-vigilant against inflation, discretionary in its approach and prepared to take action against asset bubbles, Mr Fukui has been a paragon of virtue. But for those who believe that deflation is a worse enemy than inflation, that clear guidelines should trump discretion and that central banks have no business puncturing bubbles, he has led monetary policy astray.

Mr Fukui declined to be interviewed for this article. But bank insiders profess to be puzzled by criticism of his accomplishments. “I don’t understand why there is such a split opinion over the performance of the Fukui BoJ,” says one person close to the governor. “When he arrived five years ago, the Japanese economy was in a depressed state and the immediate problem was how to fix the financial system. He took bold action and made it clear he was determined to fight against deflation. As things normalised, he started to look for the right time to abolish the emergency measures and was successful in reviving positive interest rates.”

If anything, bank officials tend to worry more about Mr Fukui’s involvement in an investment “scandal”. For a while, in 2006, the governor’s job was in doubt after he admitted to investing Y10m ($93,000, £47,000, €63,000) in a fund whose controversial founder was arrested. Although the governor did not contravene BoJ rules, which have subsequently been tightened, even close colleagues describe him as having acted unwisely and compromising the bank’s integrity.

Mr Fukui’s tenure can be divided into three phases: deflation-fighting, exit from quantitative easing, and the tentative restoration of positive interest rates.

The first phase is generally considered a success by critics and supporters alike. Paul Sheard, global chief economist at Lehman Brothers, who is scathing about Mr Fukui’s later performance, describes the governor’s early deflation-fighting efforts as “refreshingly pro­active”. Within days of taking over from Masaru Hayami, his hawkish predecessor, the governor had sharpened the bank’s fight against deflation. He raised already massive liquidity targets to an eventual tidal wave of Y35,000bn. More important, he broadened the range of assets the bank was prepared to buy.

Years previously, Mr Bernanke, flummoxed at the bank’s lack of deflation-fighting ambition, had famously encouraged it to buy any kind of asset, even ketchup. Though Mr Fukui stopped short of public tomato-sauce purchases, he did increase the bank’s share-purchasing efforts and started buying asset-backed paper from small companies, a way of circumventing a banking system that had been shrinking its balance sheet for years.

The bank’s deflation-fighting efforts were helped by developments in the real economy. Thanks to surging exports to China, Japan was at the start of what would turn out to be six years (and counting) of growth. As the economy improved, banks cleaned up their balance sheets and deflation eased.

By March 2006, Mr Fukui’s board was ready to declare deflation over. It abandoned its unorthodox policy of targeting liquidity and started targeting interest rates instead. “With the prospects for sustainable economic growth with long-term price stability, monetary policy in general should be conducted in a forward-looking manner,” said Mr Fukui, giving notice that he would not wait for inflation to appear before he pounced.

In documents laying out the new framework, the bank said it would fashion policy in line with the board’s “understanding” that price stability meant a rise of between zero and 2 per cent in the consumer price index. To underline its conservative credentials, it defined price stability as “conceptually, a state where the change in the price index without measurement bias is zero”.

Mr Sheard was not impressed. Exiting quantitative easing, he says, was achieved “on a technicality” – a month of 0.5 per cent inflation later revised down to minus 0.1 per cent. Worse, he adds: “The adoption of an ‘understanding of price stability’ that included a zero measured rate of inflation will go down as one of the most mystifying moves in the history of modern central banking and one that, by helping to anchor inflation expectations at too low a level, is inimical to the achievement of operational price stability.” Other central banks, says Mr Sheard, build in a “buffer” of at least 1.5 per cent because they regard deflation as more terrifying than inflation.

Many at the bank whisper that Japan has proved that an economy can live perfectly well with mild deflation. But Peter Tasker of Arcus Research argues that this flirtation with “good deflation” has dented nominal growth. He also bemoans the bank’s determination to meddle in corners of the economy where, he says, it has no business. Instead of targeting inflation,it spoke darkly about potential bubbles in capital spending, the carry trade and land prices. Given that land prices, even now, are well below 1990 levels and the Nikkei stock average is trading at around 13,000 compared with its 1989 peak of nearly 40,000, Mr Tasker finds such caution puzzling. “It’s very weird to be talking about bubbles when asset prices are so depressed and growth in bank lending is non-existent.”

This is the heart of the difference between BoJ thinking and that of other central banks. No polite Japanese central banker would say it, but some look at the recent rollercoaster in US markets as evidence that the Fed has been a serial bubble-blower. In concentrating on the CPI, this thinking goes, Alan Greenspan’s Fed may have stored up today’s trouble. One former senior BoJ official says: “We are living in a world where asset markets have become increasingly influential to economic activity. Monetary policy has to address that. Price stability alone is not enough.”

Mr Eldred at Daiwa Securities defends the bank’s caution. “Fukui has often been portrayed as chomping at the bit to raise rates,” he says. “The truth is that Fukui’s BoJ has been fairly pragmatic – waiting until relatively late in the economic cycle before raising rates, doing so only very gradually and pausing as soon as it became clear that the global economic outlook had worsened in 2007.”

The pause to which Mr Eldred refers has lasted a year. As well as a response to international circumstances, the delay also reflects the failure of the domestic economy to click into gear as Mr Fukui has long predicted. The governor has continually stressed his belief that record corporate profits will feed through into higher wages and consumer demand – a “virtuous circle” that might have been a good justification for the bank’s forward-looking policy.

Unfortunately, it has not panned out. Wages have stalled or even fallen as global competition, coupled with labour market and demographic changes, has short-circuited the normal mechanism by which profits flow into remuneration.

This has left Japan’s economy running on only one, export-led engine and flying too close to the deflationary ground for comfort. What headline inflation there has been is due almost entirely to higher oil and commodity prices. If commodity-led inflation fades – as many predict if the global economy slows – Japan could yet crash-land back into deflation.

Markets are factoring in the possibility that the BoJ’s next rate move will be down – not up as the governor has long intimated. It would be a severe blow indeed for the bank to put hard-won interest rate rises into reverse. But if the day for such a decision arrives, at least it will not be Mr Fukui’s to make.

Copyright The Financial Times Limited 2017. All rights reserved. You may share using our article tools. Please don't cut articles from FT.com and redistribute by email or post to the web.