Here’s why cutting interest rates hurts more than it helps

Today, the Bank of Japan said that it will print money to buy government bonds without any limits at all. That sounds radical. It’s not, as we’ll explain in a moment. But it is paving the way for something much more radical.

The Bank of Japan (BoJ) has long been a little ahead of the game when it comes to experimental monetary policy – short-term interest rates in Japan are negative at -0.1%. The BoJ realises that this isn’t ideal for the banking system (put simply, negative rates make it hard for high street banks to make money), so the BoJ isn’t keen to lower them any further.

Instead, today, the BoJ declared that it is ditching its target for quantitative easing (QE). Previously, the target had been ¥80trn (which is a little under $800bn, or £600bn). Now the BoJ has no formal guideline as to how many government bonds it will buy. The limit is simply “whatever it takes”.

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The thing is, this sounds radical. But in the context of the BoJ it’s more like a formality.

Why the Bank of Japan’s money printing promise is not a big deal

In reality, the BoJ stopped targeting a specific number of bonds to buy a long time ago. Instead, the central bank is all about controlling interest rates all the way across the curve.

To put that in English, the BoJ buys as many bonds as it needs to (or – critically – refrains from buying them) in order to keep both short-term interest rates and long-term interest rates nailed down at specific levels. In this case, the target for ten-year interest rates is 0%.

I remember a time when it would have seemed extraordinary that a government as indebted as Japan's could tap a ten-year line of interest-free credit, as if it were buying an overpriced sofa rather than running one of the world’s biggest economies. But those days are long gone now.

Anyway, the reality is that the BoJ probably doesn’t need to buy that many government bonds to keep the ten-year pinned at 0%, simply because the market knows that it will do it if it needs to – so why bother pushing it?

It also helps, of course, that the BoJ already owns nearly half of outstanding Japanese government bonds, so there’s a much smaller “free float” out there than it might appear.

There is one thing that is interesting on this front: the Japanese government – like most other governments – is increasing its own spending in order to tackle the economic effects of coronavirus. The BoJ explicitly referenced this: as Robin Harding points out in the FT, the BoJ pointed out that it was “taking into account” rising government borrowing.

That’s about as close as you can get to saying “we’re printing money so that the government can spend more without worrying about interest rates going up”, without actually saying: “OK, fine, we’re financing the deficit with printed money – happy now?”.

So what else did the BoJ do? Well, it’s significantly increased the amount of corporate debt that it plans to buy. It’s buying commercial paper (short-term corporate debt) and some corporate bonds (longer-term borrowing).

Rather than throw a load of figures at you that don’t mean anything, to put the moves in perspective, Marcel Thieliant at Capital Economics notes that at this rate, the BoJ “may soon own nearly half of all outstanding commercial paper and around 6% of outstanding corporate bonds.”

In other words, a significant number of Japanese companies may soon be servicing their entire working capital needs via the BoJ. The BoJ also made it easier and more profitable for commercial banks to borrow money from the BoJ in order to lend to businesses. It’s all about making it cheap and desirable to lend money in the face of a contracting economy.

So will it work? Does making borrowing cheaper really help much?

Why cutting the price of credit is now deflationary

Experience of the past ten years suggests a couple of things about what happens when you cut interest rates in an already heavily-indebted economy.

One, if there’s not enough demand, then making the supply of cheap credit bigger does not help to boost businesses. Two, making credit cheaper however, does allow a massive oversupply problem to develop, because no one goes bust.

Oversupply leads to deflation, which makes debt more crushing, which squashes demand further, which means you have to keep the price of debt low, and so on, in a vicious cycle.

How do you get out of this? In short, you have to kill off the debt. You could raise interest rates, which would bankrupt a lot of people and cause mass economic turmoil. Eventually you’d get to a point where the system would be “cleansed” as it were, but the pain to get there is intolerable.

Or you can give money to people or companies directly. Sometimes I hear objections to the idea of giving stimulus payments to individuals because it’ll only go on repaying debt. But this is only true inasmuch as it boils down to the size of the stimulus.

If you give people money at a rate that enables them to wipe out their debt faster than it builds up, then this is definitely stimulatory of demand. At some point, you reach critical mass and that money will get out there.

To be clear, I’m not giving a view on whether I approve or otherwise of any of these solutions. I’m just trying to spell out the problem here. We have too much debt. We can’t earn or grow our way out from under it. And the “make credit cheaper” solution is actually exacerbating the problem.

We are currently in the process of working that out. This has been accelerated by the coronavirus outbreak. The solution – which will be inflationary once it works – is going to involve central banks funding governments to, in effect, take private debt onto their balance sheets where it can then be cancelled.

Now it’s just a matter of waiting until it dawns on the authorities that this is the answer.

And we can probably expect more of this sort of thing over the coming week.

The Federal Reserve, America’s central bank, has already issued epic levels of stimulus, but I’d expect an update on how it feels this has helped, and also at least an indication of what its next steps might be if it feels this isn’t enough.

As for the European Central Bank, Christine Lagarde probably realises by now that the EU itself can’t be relied upon to get its act together in time to agree on a bailout package that would calm markets down about potential sovereign debt risks in the eurozone.

So if I was her, my main priority would be to make it clear to markets that if she needs to buy up every single Italian bond ever issued in order to protect the euro, she’ll do it.

She can’t be as direct as that, of course, so she needs to find a more Mario Draghi-esque way of convincing them. Whether she can pull that off or not this time round remains to be seen.

In the meantime, when it comes to your own portfolio, focus on good companies, stay diversified, own a bit of gold, and stick to your plan.

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