[Mohamed A. El-Erian] Bank of Japan finds it can’t win

Pity the Bank of Japan. Disappointed by the central bank’s decision at Thursday’s policy meeting to delay further stimulus measures, markets pushed the yen higher, making exports less competitive, and drove share prices lower, which damped animal spirits. This makes the prospects for a recovery of Japanese growth even dimmer.

Yet these reactions are similar to those of a few weeks ago, when the central bank surprised markets with its activism, taking policy rates into nominal negative territory.

Although it is unfamiliar in advanced economies, this seemingly inconsistent market behavior is quite common in emerging economies where policy ineffectiveness is a concern. And it speaks to an important reality: Among the systemically important central banks, the Bank of Japan has come closest to the line that separates effective policy measures from ineffective, if not counterproductive ones.

Central bank stimulus is one of the three “arrows” that the Japanese government said it would use in a renewed effort to decisively pull the economy out of two decades of economic stagnation. In practice, however, considerable central bank activism -- in the form of negative interest rates and large-scale asset purchases (both in magnitude and coverage) -- has been accompanied by inconsistent implementation of fiscal actions and insufficient structural reforms.

As the other two arrows failed to fully materialize, the Bank of Japan decided earlier this year to experiment further with unconventional monetary policy. But its attempts produced counterintuitive results, including an appreciation of the yen even as interest-rate differentials and asset purchases were widening compared with the rest of the world. The result was to expose the central bank to considerable public questioning, in particular through the political process.

In such an environment, it is understandable that officials decided on Thursday to hold off further policy activism. But in doing so, they find themselves in a Catch-22 of contributing to anti-growth asset-price movements seemingly regardless of what they do or don’t do.

Such a policy outcome is rare in advanced economies, where policy credibility and institutional robustness are taken as givens. After all, central banks in these economies can even affect outcomes through verbal intervention, including the deployment of the all-powerful “whatever it takes” mantra.

These kinds of results are far more common in emerging economies where policy credibility and institutional strengths aren’t established. That often is demonstrated when central banks lose control of the currency -- most in the context of disorderly depreciations -- almost regardless of their interest rate actions.

The Bank of Japan’s policy predicament should be monitored very closely by other central banks, starting with the European Central Bank and the People’s Bank of China -- which, along with the Federal Reserve, have been forced to rely on the prolonged use of unconventional policy actions and forward guidance to keep their economies humming in the absence of a comprehensive policy response.

The market response on Thursday highlights the urgent need for a policy handoff -- away from over-reliance on central banks and toward measures that involve pro-growth structural reforms, a rebalancing of aggregate demand, addressing pockets of over-indebtedness and improving regional and global policy coordination.

The advanced world already has experienced one unpleasant set of circumstances that is more common to emerging economies: structural rather than cyclical headwinds to economic recovery. Now some of these developed economies may be about to experience another unfamiliar form of disruption. The Bank of Japan’s evolving experience should serve as an important warning sign that central banks should take seriously the risk of growing policy ineffectiveness.

By Mohamed A. El-Erian
Bloomberg

Mohamed El-Erian is a Bloomberg View columnist. He is also the chief economic adviser at Allianz SE. His new book is “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.” -- Ed.