Central Banking Vodooo

Last month in a surprise move The Bank of Japan (BOJ) moved to negative interest rates, meaning deposits of regulatory capital for some banks will be charged. Theory says this will incentives financial institutions to lend, and by doing so stimulate the economy. Theory. However many are comparing BOJ’s move to a step through the looking glass. Or what I like to call Central Banking Vodoo.

A good question: why would consumers willingly take on debt in a deflationary environment?

Simple answer: they wouldn’t. Deflation magnifies debt, as repayments over time use units of currency (i.e., Yen, Dollar, Euro, etc) that can purchase more not less. That’s what deflation does — prices fall. You don’t borrow in a deflationary environment, you borrow in a inflationary environment, where the purchasing power of currency declines over time. Pretty simple economics, really.

And both consumers as well as businesses know this. IF borrowing does occur you can be sure funds won’t be used for frivolous spending, aka “stimulating” the economy via mindless consumption. I suspect those borrowing in such an environment will be using funds to invest in assets that generate significant cash flow. And probably not even assets found in Japan e.g., property in London or New York, to name but two possible destinations.

Regardless, and just to illustrate how disconnected theory and some economists are from reality, as recently as November 2014 many investment banks were targeting 130 Yen to the USD.

And by March, 2015 a survey of 27 economists suggested 140 Yen to the USD was achievable, applauding BOJ’s efforts to stimulate inflation and weaken the Yen.

Well, as the chart below shows, once again markets refused to cooperate with theory. As soon as BOJ announced it’s negative interest rate policy the Yen obligingly weakened. For one day. And then once again began to strengthen. At this rate the Yen certainly isn’t hitting 140 to the USD anytime soon.

Key takeaway: there is theory and there is markets. And they may disagree. The trend seems to be for strong Yen.

Possible contrary indicator: as I write this post Goldman Sachs apparently has abandoned their weak Yen call. Imagine that.

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