By holding interest rates close to zero, Japan has been been the global carry-trade’s best friend, fostering liquidity worldwide for purposes, mainly, of promiscuous financial speculation. However, the Bank of Japan recently announced that zero-interest rate conditions will end later this year, a prospect that is likely to add some deflationary ballast to a financial environment that has been gaseously buoyant since around the mid-1990s. I recently heard from a correspondent on this topic, a financier who wishes to remain anonymous. He posted the following to a chat group that I  frequent:

“How will the Japanese financial markets be returned to a ‘normal’ state of liquidity? I had the opportunity to attend a symposium this afternoon, hosted by a primary dealer as well as some representatives from several GSEs and supranational agencies, and an active topic of discussion was the impending change in Japanese monetary policy.  The Bank of Japan has indicated that during 2006, zero-interest rate conditions will almost certainly come to an end.  What was not widely known amongst the participants was that the BOJ has expressed that it intends to have the banking system eliminate its excess reserves over just THREE MONTHS, probably around the third calendar quarter of 2006.

“One of the main policy tools that the BOJ has used over the past several years has been to inject (and to take steps to maintain) over Y34 trillion of reserves in current account deposits (similar to the reserve requirements in the US) for its member banks.  The statutory reserve requirement for these banks is but a mere Y5.5 trillion, so the Y28.5 trillion ($241 billion) above and beyond the required minimum is invested in a wide variety of money market instruments, a substantial portion of which consists of US$ assets, or term repurchase agreements collateralized by dollar denominated assets.  Apparently, the BOJ has determined that the easiest way to drain this excess liquidity from the system is to simply let the repurchase portfolio mature on schedule, without rolling it over as they had been doing.  Yikes! 

Audience ‘Incredulous’

“Now...the opinion of the audience was a mixture of incredulity and an almost morbid curiosity about what the effect of this rapid diminution in money supply will be.  Frankly, I can't think of a similar parallel in modern times in which so much money (short-term repurchase agreements are essentially money) is destroyed in such a short period of time, let alone having it destroyed on a schedule.  Certainly if it takes place over a period of just three months it will be painful for dealers and market participants in the US treasury market, probably much less so in the JGB market.

Will this be deflationary?  Will the BOJ need to extend its timeframe beyond three months?  If nothing else, we know that the ending of the zero-interest rate policy will at the least be very exciting.”

‘No Liver’ as Punishment?

And here’s the response of another member of the chat group, expressing some thoughts that occurred to me as well. Is it possible the U.S. central bank does not have a monopoly on brash policies that fundamentally misunderstand the economy, if not to say, basic economics?:

“Interesting concept - sounds like they are trying to kick-start domestic demand by way of threatening the populace with higher prices; i.e., the take-away sale: If you don't buy now, tomorrow it will cost more. I can't imagine it working with an aging demographic that neither consumes nor invests, financial markets that are still restrictive to foreign investment, a sovereign fiscal system that is essentially tapped out; i.e. sovereign debt at twice GDP now, a postal savings system that has not yet begun to privatize, restrictive immigration policies, a homogenous society still desiring of a return to pre WW2 delusions of superiority and hemispheric hegemony.

“It would be interesting to know who the advisers were on this tactic. Sounds about as plausible as a stand alone policy as me threatening to not let my daughter eat liver unless she makes her bed.”