A rocky road to financial normalization
In financial markets, the winter landscape can unfold overnight. The failures of Silicon Valley Bank (SVB) and Signature Bank in the US led to a chain reaction to the rescue acquisition of Credit Suisse Group.
In doing so, the US Federal Reserve Board (Fed) and Federal Deposit Insurance Corporation (FDIC) moved quickly. In addition to the lending at the discount window as the “lender of last resort” to protect the deposits of bankrupt banks, it has also newly established a fund supply scheme that uses US government bonds as collateral at book value. The Federal Home Loan Bank (FHLB), known as “the second lender of last resort “as well as the Central Bank Swap Agreement were mobilized to supply fund to the market.
The US bank failure in March was largely due to a rapid outflow of deposits and poor risk management of held-to-maturity bonds. However, the Fed had raised its policy interest rate by 4.5% in a short period of time until then, in addition to the shift from quantitative easing (QE) to quantitative tightening (QT). While firmly maintaining the QT as a monetary policy, it implemented a large-scale fund supply to stabilize the financial market.
Since the end of 2008, the Fed has implemented three QEs to overcome the risk of deflation. Including the response to the COVID-19 pandemic, it will be the fifth large-scale funding. However, this is the first time that market funding and absorption of funds have been implemented simultaneously; it points to a lack of consistency.
Even in the UK, after the former Truss government announced fiscal expansion measures that ignored the implications for the medium-term economic and fiscal outlook, pension funds that failed to manage their assets recorded huge losses. The pound and government bond prices plummeted, forcing the Bank of England, which had been raising interest rates and converting to QT, to engage in a massive government bond purchase.
Prolonged QE changes the behavior of financial institutions, making it difficult to implement QT even with ample bank reserves. The Bank of Japan started QE in 2001. In the last decade it has implemented extraordinarily scaled QE.Thus,it’s all the more difficult to get out of it.
If the BOJ judges that its 2% inflation target has been achieved, the first step toward monetary normalization would be to review the yield curve control policy, but the vulnerability of the US financial markets could make it difficult to implement. During the 2008-2009 financial crisis, Japan’s real gross domestic product (GDP) declined twice as much as the United States. If financial stress rises, a US interest rate hike would reduce Japanese industrial production by three times that of the US.
Market interest rates in the US have remained relatively stable after the bank failure in March. However, if the tightening of loan conditions due to financial instability equates to an interest rate hike of about 1%, Japan could run out of steam toward recovery before the US plunges into recession. It is unclear how long the current “High Dollar Cycle” will last.
Even if the BOJ is fortunate enough to be able to shift to a phase of interest rate hikes, the disposal of its massive holdings of government bonds and exchange-traded funds (ETFs) will be a difficult task. Considering the impact on the market sales of JGB and equity would be difficult to implement. Government bonds should be held until maturity, even if it takes 10 years, and the reduction without sales should be attempted by stopping reinvestment.
ETFs, which new governor Kazuo Ueda calls “a big problem,” will likely have to be held permanently, although there are proposals to sell them on the market or transfer them to pension funds. It should also be recalled that the Swiss National Bank (central bank) has around 80% of its assets in foreign currency bonds and shareholdings.
(English translation of Morning Edition of the Nikkei with 2023/5/5)