Federal Reserve Is Trapped In A Cage Made In Tokyo

As Federal Reserve Chairman Jerome Powell ponders how much latitude he has to hike interest rates, realities in Tokyo suggest the answer is not much.

In March, Powell’s team hit the monetary brakes for the first time in three years. That 25 basis points move came at a moment when inflation is rising the fastest since the early 1980s. It fueled expectations are there’s lots more tightening where that came from.

Yet the Bank of Japan’s plight demonstrates why the Powell Fed may be more boxed in than investors appreciate.

Granted, the Fed and BOJ aren’t ideal comparisons right now. But the BOJ pioneered the monetary sand trap that’s warped the perspectives of central bankers from Washington to Frankfurt to Sydney. And the fact the BOJ is stuck at zero—and in quantitative easing mode—explains in part why the Powell Fed won’t be tightening with the urgency that 8.3% inflation would seem to demand.

The common thread is the ways in which giant economies have gotten so used to near-unlimited free money that they can’t fathom going without it. It’s become the central banking equivalent of a public entitlement.

Detox is something Japan has never figured out how to do. The quick history is that the BOJ first cut rates to zero in 2000, an unprecedented act by a Group of Seven economy. In 2001, then BOJ Governor Masaru Hayami invented modern QE.

Trouble is, the BOJ can’t find an exit. It’s kept the monetary engine in 5th gear year after year. Japan’s entire $5 trillion economy got addicted. Government officials, corporate executives, households and investors took for granted that the BOJ would leave the yen printing presses on “high” indefinitely.

There was indeed a brief moment around 2006 when the BOJ tried to wean the nation off the monetary sauce. It even managed to pull off a couple of slight rate hikes.

It didn’t work. The public outcry was fierce and the economic fallout for business confidence and investment dynamics was even worse. By 2008, the BOJ returned borrowing costs to zero. Then QE again. In a sense, the financial empire struck back. Pleas for additional monetary hits were answered by an enabling central bank. And that’s unfortunate.

Two decades of excessive monetary welfare, essentially, ended up deadening the very animal spirits that Japanese policymakers had been trying to revive. Incentives for government officials and corporate CEOs to disrupt, restructure, innovate or take risks fell away.

Why implement unpopular or risky new strategies when it’s easier just to harness the BOJ’s liquidity giveaways? The irony is that in 2012, when then-Prime Minister Shinzo Abe took power pledging to reform the economy, he too fell back on the BOJ’s printing presses.

Abe hired Haruhiko Kuroda to find a higher stimulus gear and end deflation once and for all. Governor Kuroda hit the gas more aggressively than ever before, taking the onus off Japan Inc. to reanimate its innovative spirit or increase productivity. Rather than raising its economic game these last nine years, Japan increased the dosage of steroids. This basically forfeited the future to China.

Enter Powell, the least confrontational Fed leader in decades. He bowed to former President Donald Trump and cut rates back to zero. Then in 2021, under President Joe Biden, Powell refused to get ahead of the inflation curve with a rate hike or two.

Back in, say, September 2021, it was possible that the inflation surge was transient, related to supply-chain turmoil that would pass. But central banking is a confidence game. All it takes to guide investor perceptions are small, but deliberate steps to curb speculation. Now it’s arguably too late as Russia’s war in Ukraine turns price increases into a five-alarm crisis.

Odds are, the Fed will hike rates again soon. After that, though, expect long periods of “watching and waiting” as Powell’s team tries to spin rising inflation as the better of two scenarios—the other being a deep recession caused by aggressive monetary tightening.

No Fed leader wants to be blamed for a downturn. And given the fallout from Covid-19, inflation, supply-chain troubles, geopolitical tensions, irrationally high equity valuations and a surging dollar, the stakes are increasingly high. The costs of a policy mistake are as great as they’ve ever been. It could easily send U.S. stocks down even more sharply.

To be sure, economists have a point when they that argue today’s inflation is less about easy money than demand/supply mismatches and massive fiscal largess. A dearth of tech investment to needed increase U.S. productivity hardly helps. But so much of central banking is psychological. Right now, there’s little trust that Powell knows what his job requires. More importantly, there’s little confidence he’ll have the courage to make unpopular decisions.

Japan reminds us that it’s infinitely easier to slash rates to record lows than to restore normalcy. This, in a nutshell, explains why talk of a 1994-like tightening cycle by the Powell Fed is greatly exaggerated.