On April 7, the European Central Bank (ECB) released data on its first month of quantitative easing, revealing that all was going according to plan. Economic signals coming out of Europe from the first quarter have been positive, and talk has already begun on the prospect of tapering — the process of winding down quantitative easing. In contrast, the Bank of Japan released figures in March showing that its renewed surge of quantitative easing launched in late 2014 had failed to boost inflation to the desired levels, sparking talk of yet another redoubling of the campaign. But on April 8, the Bank of Japan announced no change in its bond-buying program and suggested that it expected inflation to remain stagnant for some time.
In many ways, the two central banks are facing similar challenges. Both have also resorted to the same methods of coping with those challenges. So why does ECB President Mario Draghi look like an all-knowing seer while his Japanese counterpart, Haruhiko Kuroda, appears to have run out of ideas? The answers lie in the different contexts of the two economies, and Draghi and Kuroda could end up exchanging roles as time passes.
Different Relationships With Quantitative Easing
The most obvious difference between the two central banks' relationships with quantitative easing is their longevity. The Bank of Japan is widely credited for inventing quantitative easing at the beginning of the last decade, and it has used it liberally since then. The ECB, constrained by politics and tradition, was the last of the major central banks to undertake the controversial policy, launching it on March 9. Japan has been battling deflationary pressures for 25 years, as adverse demographics and the effects of an economic crash conspired to create two lost decades of stagnation. Europe's major crash, meanwhile, occurred in 2008, and its aging problem is less advanced than that of Japan.
These different histories have shaped variant narratives around quantitative easing. In Japan, this latest burst of bond buying is the "first arrow" of Abenomics, the whirlwind plan launched by Prime Minister Shinzo Abe in April 2013. This new grand plan consisted of raising inflation to a 2 percent target, then using fiscal stimulus and structural reforms (the second and third arrows) to reshape the economy into a model that could grow sustainably.
In Europe, the ECB was the most hawkish of all the central banks. In fact, it actually pushed up interest rates in 2011, after which the monetary situation deteriorated to such an extent that it then became the first major central bank to go to another extreme, taking rates down into negative territory in 2014. This move drove down the value of the euro, making European exports more competitive. The world closely followed the implementation of the ECB's quantitative easing program in the year before the program's launch, and the markets had a long time to get ready for it, moving into sovereign bonds and making countries' interest rates drop to record lows throughout last year. Thus, the effects of quantitative easing have been felt for a long time in Europe, even before it began.
Japan, the quantitative easing veteran, is using dramatic numbers of bond purchases as the first part of a massive experiment to wrest the economy out of its long slump. Europe, by contrast, is quite new to the threat of deflation and has never before embarked on a program of bond buying. This novelty value appears to have made the eurozone more susceptible to the benefits of quantitative easing, even before the program began in earnest.
More Recent History
A major factor emerged in the second half of 2014 that has shaped the narrative in both Europe and Japan this year. Between July 1 and Dec. 31, the price of oil dropped by 50 percent. Such a drop has an immediate downward effect on prices, since everything whose manufacture or transport depends on oil becomes cheaper, and inflation rates drop. This effect occurred all over the developed world. But this phenomenon is what is known in some circles as "good deflation": The money saved on oil goes to work elsewhere in the economy and, after a pause for the low oil prices to pass through the system, there should be a boost to growth that should then push up inflation in the medium term. Herein lies another fork for the two economies.
In Japan, where the initial measure of success for Abenomics is somewhat linked to higher inflation, the downward effect of oil prices on inflation is a negative development. Inflation has slid to zero just ahead of the Bank of Japan's original deadline for hitting the 2 percent target. The deadline has since been moved to mid-2016.
In Europe, although low inflation figures in January were the final straw that forced the European Central Bank to act, the Continent is focused on growth, and a fear of deflation has not yet taken hold. As a result, there is much more tolerance in Europe for sub-zero inflation, because there are strong signs that the weak exchange rate and low oil prices are beginning to have a positive effect on growth (though quantitative easing probably was not the main cause).
Japan does not even have promising signs of growth at this stage, possibly because it is still working its way through the economic trauma of a value-added tax hike last year. Nevertheless, the weak yen and low oil prices will eventually do their work; it is just politically painful for Abe and Kuroda to be patient long enough for this to happen as inflation rates stagnate.
Limitations of Quantitative Easing
So we return to the present day and the divergent attitudes of the European and Japanese publics. In Europe, a nascent quantitative easing program is being celebrated as an immediate success, though it is probably taking credit for the other factors at work. In Japan, Abenomics is tottering, and some are calling for even more quantitative easing. Meanwhile, rumors swirl of a split between the prime minister and the central bank governor that could cause a potentially fatal crack in the united front that sustains the grand plan. In fact, both central banks can barely continue buying bonds at the present rate, much less at an increased rate if either bank chooses to take quantitative easing further.
The Bank of Japan has been buying government bonds longer than any other central bank. Moreover, it has been buying them at the fastest rate, particularly since October 2014. The time must come when there will be no more government bonds to buy. That moment will arrive long before the bank owns all the bonds that have been issued. A sizable portion of the market will not want to sell its bonds, so instead of having to buy 100 percent of the bonds, the bank's maximum may be closer to 50 or 60 percent of the overall market (the bank is currently set to own about 36 percent of Japan's 10-year bonds by the end of 2015).
When the Bank of Japan runs out of bonds to buy, the quantitative easing program will have run out of road. Indeed, signs are already emerging of low bond availability; volatility recently rose to its highest levels since April 2013, and in October 2014 the Bank of Japan failed to hit its bond-buying targets. The Bank of Japan conceivably could expand its purchases of other assets, digging more deeply into real estate, corporate bonds and exchange-traded funds. But such purchases make up about one-eightieth of the annual total of the bank's purchases. Every time a government enters the markets in force it tends to change their shape, and it is quite possible that such a departure from the norm could have unexpected consequences. As bond availability lessens, the Bank of Japan will fail to hit its monthly targets more frequently, and any increase in the rate of quantitative easing would speed up this process.
In Europe, the central bank is less restricted. Because it represents a divergent group of countries, the ECB must be careful not to be seen to be aiding one country more than the others, particularly if that country is in financial straits. The bank created strict limits on the amount of bonds it could buy — up to 25 percent of a single issue and 35 percent of any country's overall issuance. It even conveniently omitted Greece from the windfall of quantitative easing, since its outstanding debts already exceeded 35 percent of its bond issuances. The ECB is unlikely to breach these limits under the current program. Nevertheless, they do stop the bank from buying bonds more quickly or extending the program should it need to.
The long run-up to quantitative easing also created its own problems, since the flood of investment into bonds that preceded it drove their prices up and their interest rates down. To avoid buying overpriced bonds, the ECB decided not to buy any with interest rates lower than its own base rate of -0.2 percent.
Government bonds' interest rates are falling all over Europe, but Germany, the Continent's largest economy, is likely to feel the effects of the decision first. Interest rates for 30-year bonds are only 0.68 percent and falling. The lack of available bonds is particularly problematic because the ECB needs to buy its quantities in line with national economy sizes. Finally, Germany's achievement of balancing its budget and writing it into German law means that new bonds are not being issued, with scarcity likely to increase rather than improve.
As in Japan, there is a possible overflow — where a national central bank is unable to buy the required amount of its own bonds and should instead buy the bonds of "supranationals," a list of approved European institutions such as the European Investment Bank. The available number of such supranational bonds is not large, however, and their purchase will also be subject to the 25 percent rule, so this overflow cannot be expected to last long. But such issues are unlikely to appear immediately. It is also likely that the ECB's bond policy will hit one or more of these walls long before the end of 2016, when the policy is scheduled to conclude.
Forces in Play This Year
The twin external forces working on the Japanese and European economies may or may not be able to sustain themselves as the year progresses. The price of oil is expected to remain weak, but any number of surprise shocks could drive it up. Though the quantitative easing programs will help keep the currencies weak in Europe and Japan, a potential opposing force could emerge from the United States. During the last 12 months, the strong dollar has provided a hard surface against which the yen and euro could push themselves down. However, low U.S. job figures combined with other warning signs suggest the U.S. economy could be entering a weaker period, depressing the dollar and providing buoyancy for the yen and the euro that has not existed recently. Neither Japan nor Europe should take the weak currencies and the low oil price for granted; either factor could change at any moment.
In the case of both grand plans, quantitative easing was just the start, with fiscal stimulus and structural reforms needed to truly fix the economies. In Japan, while fiscal stimulus has been forthcoming, structural reforms have taken much longer. In Europe, the lack of fiscal stimulus has been somewhat masked by the low oil price, but the structural reforms are also proceeding sluggishly in France and Italy, the primary offenders in need of such changes.
The effects of quantitative easing are generally agreed to be only temporary. When the favorable winds of oil and currency fade away, the central banks could again be pressured to scale up their bond purchase programs, particularly since this is often the most politically acceptable move to the general public. However, both central bank chiefs know that the limits of their quantitative easing programs are approaching.