European central bankers agitating for higher interest rates to quell inflation may be ignoring the lessons of Japan’s economic history.
As the European Central Bank and Bank of England consider tightening monetary policy, HSBC Holdings Plc and Fathom Financial Consulting warn officials risk misjudging the inflation threat and may end up hurting their recoveries. That’s what repeatedly happened in Japan in the past quarter century as policy makers constrained credit only to reverse within months when expansion faltered.
“The danger is of a policy mistake,” said Stephen King, HSBC’s London-based chief economist and a former U.K. Treasury official. “In an attempt to control inflation this year they could set the scene for more disappointing growth in the future as happened in Japan.”
Japan’s woes, which began with the bursting of an asset bubble and extended beyond the “Lost Decade” of the 1990s, were a reference for central banks seeking to avoid its errors when battling the credit crisis. Ben S. Bernanke, now chairman of the U.S. Federal Reserve, said in 2003 Japan’s “performance is due almost entirely to a very poor monetary policy.”
Now some are looking to its track-record on withdrawing stimulus, with U.K. policy maker Adam Posen saying last month that colleagues should learn from Japan’s 2000 interest-rate increase, which “led to bad macroeconomic outcomes.”
“Monetary accommodation can help the recovery and tightening can undercut a nascent recovery, which is what happened in Japan,” said Daniel Leigh, an International Monetary Fund economist who wrote a 2009 study on Japan.
Pressure for a rate increases has mounted in the U.K. and euro-area as food, fuel and higher indirect taxation propel inflation beyond central banks’ limits. That’s triggered concern it will spark broader price increases and that crisis rates are no longer valid. At the same time, the U.K. economy shrank 0.6 percent in the fourth quarter, the euro-region’s so-called peripheral economies are battling a debt crisis and policy makers are unsure if the inflation shock is temporary.
President Jean-Claude Trichet signaled on March 3 that the ECB will raise its benchmark rate from 1 percent in April, while three of the nine members of Bank of England Governor Mervyn King’s Monetary Policy Committee this month voted for their key rate to be increased from 0.5 percent.
HSBC’s King draws parallels with the early 1990s, when the Bank of Japan more than doubled its key rate to 6 percent as an oil-price surge during the Gulf War pushed inflation as high as 4.2 percent. Governor Yasushi Mieno then had to backtrack as inflation evaporated, slashing the benchmark to less than 2 percent by the end of 1993.
The risk is that shocks such as an oil-price surge can sometimes prove more deflationary than inflationary by squeezing spending power, said King at HSBC. His fear is that’s what happening in Europe now as the price of crude trades above $100 a barrel, close to the highest in more than two years.
“Dealing with a near-term inflation threat is all very well, but with oil-price spikes, there’s no such thing as a free lunch,” said King. “As we now know, the longer-term costs were enormous: stagnation, deflation and economic underperformance.”
Japan’s failure to escape a slump left its economy less prepared for the shock of this month’s earthquake and its after- effects with rates already near zero and debt twice the size of its economy.
Japan’s rate shift in 2000 is also telling, said Erik Britton, a director at Fathom in London and a former Bank of England economist. That August, the BOJ lifted its key rate for the first time in a decade to 0.25 percent, noting an improving economic recovery and the end of deflation meant a zero rate was no longer justified. The return of deflation and economic contraction meant policy makers were again cutting their rate back to 0.15 percent six months later.
Like Japan, the U.K. has failed to tackle an overhang of debt, in its case from households, and the recovery remains weak, said Britton.
“The essential lesson from Japan is unless the underlying structural cause of weakness in the economy is solved, then as soon as you start to tighten policy there is a risk it is so fragile you may just push it back into recession,” he said.
Nobel Prize-winning economist Joseph Stiglitz warns fiscal policy makers are also ignoring Japan. The U.K. is imposing the biggest budget squeeze since World War II and raised its value- added tax to 20 percent from 17.5 percent in January. Euro-area nations spooked by the debt crisis are embracing austerity. To Stiglitz, that echoes Japan’s 1997 effort to balance its budget, which included a 2 percentage point increase in the consumption levy now blamed for renewing recession.
“Europe is really facing exactly the same kind of risk,” Stiglitz told Bloomberg Television on March 8.
Concern that constraining monetary policy spells a Japanese redux is not without high-level support. The Bank of England’s Posen said on Feb. 22 that Japan’s 2000 pre-emptive strike against inflation dealt a “significant blow” to policy makers’ credibility that “further de-anchored inflation expectations.”
“I am not forecasting that a tightening of policy now by the MPC would lead to deflation in U.K., though I would not rule that out,” said Posen. “I am arguing that it would be a similar mistake for the MPC to try to prove its counter- inflationary toughness just for the sake of chatter about rising inflation expectations.”
Almost three years after the ECB raised its key rate only to cut it three months later as the credit turmoil deepened, Trichet now says a rate increase is “possible” in April after inflation broke the ECB’s 2 percent limit in December.
U.K. inflation has accelerated to 4.4 percent and the Bank of England said this week there is a “significant risk” it will exceed 5 percent in the coming months. Policy maker Andrew Sentance said failure to act now “risks a more abrupt and destabilizing” rate increase later.
Thomas Mayer, chief economist at Deutsche Bank AG in Frankfurt, says the comparisons with Japan are misplaced as the ECB and Bank of England have inflation goals that are being breached and that it would be risky to keep rates low for long. Unlike Japan in the 1990s, European policy makers went all out in supporting their economies through the crisis, he said.
The European central banks may still tread carefully, said Masaaki Kanno, a former BOJ official and now chief Japan economist at JPMorgan Chase & Co. in Tokyo. His colleagues anticipate both will limit increases to 75 basis points this year.
They seem to “think the economic outlook should be OK if they hiked rates, but there are risks ahead so they need to be careful,” said Kanno.