occur much sooner than it ordinarily would and may even take place before the recovery takes hold.
If the rise in long-term rates precedes the economic recovery, people who had planned to borrow money and invest it in anticipation of inflation could start to have second thoughts, throwing a damper on the nascent recovery.
Richard Koo: Rising JGB yields could also hamper banks’ ability to supply funds
In Japan’s case, moreover, the arrival of higher long-term interest rates prior to recovery could lead to large losses for the financial institutions holding large JGB portfolios, with the resulting shortage of capital crimping their ability to lend.
Losses on banks’ bond portfolios could prevent them from lending by causing an impairment of capital ratios. Funds supplied by the BOJ under the new easing regime would then remain in the banking system, further clouding the prospects for recovery.
In the traditional pattern, whereby long-term rates rise only after the recovery takes hold, private-sector demand for funds is lifted along with the economy and provides a boost to bank earnings, so there are earnings to defray losses in banks’ bond portfolios caused by rising rates. But that is not the case when the order is reversed.
Richard Koo: Rising long-term rates will also affect share prices
On this point, the higher share prices that have resulted from the weaker yen will provide a significant cushion to offset potential losses coming from banks’ bond portfolios. But a material rise in long-term interest rates could also weigh on share prices.
The portion of the recent stock market gains that is attributable to improved corporate earnings via the weak yen is justified over the long term with the argument that a strong currency is not likely soon for a nation already running large trade deficits.
The problem is that some of the recent gains cannot be justified by the weak yen alone, and these could evaporate if long-term interest rates rise.
Richard Koo: Advance rise in interest rates could bolster calls for austerity
The potential ramifications of an early increase in long-term interest rates go beyond financial institutions to include the government. In an ordinary recovery, inflation concerns—and the corresponding rise in long-term rates—emerge only after the real economy is in recovery. The rise in tax revenues from the recovery is then capable of offsetting the government’s increased debt service costs.
In the present case, however, the Japanese authorities are trying to generate inflation first and then hope for recovery, which means debt service costs will increase before tax revenues do. Such a state of affairs could easily lead to calls for early fiscal consolidation given the size of the nation’s public debt.
Richard Koo: Austerity + shortage of borrowers would break the recovery’s back
Such calls are already being heard in the media. But the reason the BOJ is engaged in quantitative easing in the first place is that the private sector refuses to borrow money and continues to save in spite of zero interest rates. The government has prevented the economy from entering a deflationary spiral by running fiscal deficits and serving as “borrower of last resort.” If rising rates prevented it from playing that role any longer, there would be significant ramifications for the economy.
In other words, an increase in long-term rates would prevent the deployment of fiscal stimulus—the second component of Abenomics. Stopping the government from borrowing the 8% of GDP that households and businesses are saving at a time of zero interest rates could easily lead the economy back into recession.
Richard Koo: Kuroda succeeded in fostering inflationary expectations
Businesses and households have until now refused to borrow money in spite of zero interest rates. The lack of borrowers means the money multiplier is negative at the margin. This means, no matter how much liquidity the central bank supplies, the liquidity remains within the confines of financial markets and is unable to contribute to either economic recovery or inflation.
But by unveiling what could be called a reckless program of monetary accommodation, Mr. Kuroda has succeeded in persuading the media and the general public—who are unaware that the money multiplier has turned negative at the margin—that inflation might just be on the horizon.
Pundits in the media, and especially on television, have devoted a great deal of attention to the subject of inflation, and the more people hear about it the more they are inclined to believe it, even if it is not true. As a result, even those who were reluctant to borrow money are starting to take a more positive attitude.
Of course some of this change is also attributable to the rising stock market, something made possible indirectly by Japan’s trade deficits, which have prompted the G7 and G20 to tolerate a weaker yen in spite of their past opposition.
Richard Koo: Long-term rates may rise before real economy recovers
Repairs to Japan’s private-sector balance sheets have already been completed. That businesses and households still refused to go into debt can be attributed to the “trauma” of struggling to pay down debt for 15 years. This was not a problem of being unable to take out new loans because of excessive indebtedness, but was instead a psychological issue.
Mr. Kuroda’s psychological tactic of repeating a lie often enough that it becomes the truth has succeeded brilliantly.
The problem is that it works on lenders as well as on borrowers. Moreover, borrowers are agents in the real economy and need time to react, whereas lenders are financial sector entities that can respond instantaneously, creating the possibility that lenders will react sooner than borrowers.
The fact that the BOJ has also reversed the traditional order of things and is trying to spark an economic recovery by generating inflation has increased the possibility that higher long-term rates driven by inflation concerns will emerge sooner than higher longterm rates rooted in a recovery in the real economy.
Time inconsistency problem hangs over BOJ
If we refer to higher interest rates driven by an economic recovery as a “good” increase and higher rates sparked by inflation concerns as a “bad” increase, I think there is a significant possibility that the latter will emerge first in this case.
That would not only weigh heavily on the first shoots of private loan demand to arise in a long time but could also focus attention on the banks’ and the government’s financial health, damping the
