Frances CoppolaContributor
Never pick a fight with a central bank. The only one who gets hurt is you. Unless, of course, you are another central bank.
Central banks routinely intervene in the markets to influence the prices of assets, commodities and currencies. That’s the way monetary policy is conducted. It’s the principle behind QE.
Generally, everyone co-operates. When a central bank announces that it intends to buy assets, investors queue up to sell – even though they presumably have optimized their asset portfolios. Some of those who opt to sell to a central bank would no doubt have sold anyway. Others perhaps bring forward sales that they would have made at a later date. And others may seize the moment to make opportunistic sales. But there has never yet been a central bank that couldn’t find assets to buy when it wanted them. If a central bank wants to buy assets, markets make assets available.
The reason for this is something of a mystery, but I think it is really simple game theory. The reason everyone co-operates with central bank bond buying programmes is that there is no point in not doing so. A currency-issuing central bank has infinite resources. No-one else does. The only way of winning this game is to co-operate with the player who can’t lose – i.e. the central bank. So in the end, the central bank will buy everything it wants to, simply because it can. And because market participants believe this, an asset-buying central bank effectively controls the market price not only of the assets that it buys, but also of the currency that it issues to buy them.
Japan’s central bank is buying large amounts of assets as part of the Japanese government’s combined monetary and fiscal stimulus program designed to end Japan’s long-standing economic stagnation. Here’s what happened to the yen today (chart from Bloomberg ):
That sharp drop occurred when the Bank of Japan announced a massive expansion of its asset-buying program. On its website, the Bank of Japan states that the purpose of the asset-buying is to maintain inflation at the Bank’s target of 2%. But the immediate effect was to devalue the yen and raise stock and bond prices.
Inevitably, the Bank of Japan’s action was hailed as “currency war”. In the Wall Street Journal, Michael Casey writes:
A currency war looms – not a 1930s-style scorched-earth conflict, but a damaging stealth war that will exacerbate the global economy’s woes and distort domestic political agendas…..As a weakening exchange rate drives down the price of its cars and electronic goods overseas, Japan creates competitive challenges for other countries’ producers, putting jobs at risk and policymakers in those places under political pressure to respond.
And he warns:
The biggest players in the global monetary system have mostly resisted direct tit-for-tat responses to Japan’s yen-weakening moves over the past two years. But it’s only a matter of time before their policymakers use words or actions to combat its effect. The upshot: even more global deflation and sluggish growth.
Aha. So it is not quite true that a currency-issuing central bank has no opponents. No-one in the private sector will oppose it, unless they have a deathwish. But other currency-issuing central banks might, if they perceive its actions as threatening to their own economies. Economic wars are played out between central banks. Market participants will co-operate with the central bank that adopts the game strategy that best fits their own interests. And as each central bank defends its own economy, when central banks are fighting, markets fragment along national lines. As Casey says, central bank wars can be very damaging.
So far, central banks have been fairly tolerant of the Bank of Japan’s market intervention, no doubt because large though the Japanese QE has been relative to the size of the Japanese economy, until now the Fed’s QE program has dwarfed it. But the Bank of Japan has now doubled its QE program, while the Fed has ended QE. Will central banks be quite so tolerant now – or will we see a round of defensive responses to the Bank of Japan’s move?
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