Almost a year ago, the Bank of Japan (BoJ) embarked on the most aggressive programme of quantitative easing (QE) we have ever seen. Within nine months the BoJ has been more aggressive than the Federal Reserve Board or Bank of England (figure 1). The stated objective of these policies is to raise the rate of inflation to 2%. For most of the last decade Japanese inflation has been stuck at close to -1%.
Why is this policy highly likely to fail? What we know about QE is that it is very important during a financial crisis: Increasing the liquidity available for banks allows money markets rates to normalise, but post-crisis its effects seem negligible, particularly on inflation. Inflation is today lower in the UK and US than when QE was first embarked upon.
There is no reason to expect Japan to be different. This is not even the first time Japan has embarked on similar policies: a post Asian crisis bout of QE starting in March 2001, not dissimilar in scale to what the Fed has done had no discernible impact on inflation.
There are good reasons to expect little impact of QE on the economy, but significant impact on asset price volatility. Even from a monetarist perspective, QE should not have much effect when: interest rates are already extremely low, and demand and supply of credit is constrained by balance sheets and preferences. The way QE should work is that as the central bank adds liquidity to the banks, the banks on-lend to the private sector, creating growth in demand and bank deposits (so-called broad money). If private sector loan demand is low, or banks risk-averse about lending this will not happen. And it hasn’t.
So why the relatively violent moves in the yen and Nikkei earlier this year (figure 2)? Small changes in probabilities can have very significant impact on asset prices, and price itself is often the main source of information. Although we don’t like to admit it, much of the time assets prices move for reasons we don’t know or understand (which explains the popularity of technical and systematic approaches). These forces are very evident in Japan. Although the probability of policy success is low, it is still higher than if Japan was doing nothing: it might work. Even if the probability of success is only 10%, the value of this option is high: Japanese equity markets would rise dramatically. The most likely cause of the rise in Japanese equities earlier this year was a recognition that Japan was doing something which might work, and a sense that other people might think it would work.
Similar price behaviour is likely looking forward. More policies of “structural” reform and cyclical measures are planned. The BoJ is also likely to embark on even more QE, as inflation fails to rise. Also an improvement in global growth can aid Japanese earnings.
The behaviour of Japanese markets in the last 12 months reveals a lot about the inherent uncertainty in asset pricing, and its impact on volatility. But there is also a key difference between the current juncture and similar phases in Japan in the last 15 years: today, Japanese equities are reasonably priced. Despite a 25-year bear market it is only recently that Japanese equity valuations have reached levels that look independently attractive. For example, today a basket of the major Japanese banks trades on a PE of around 10x with a dividend yield of 3%. This is hardly table-thumping value, but it is a very reasonable expected return. Even if nothing structural changes in Japan, these valuations imply reasonable levels of expected return. The option on a structural break is a bonus.