Updated Sept. 21, 2016 5:25 p.m. ET
The Bank of Japan
took new steps to revive Japan’s economy while the Federal Reserve prepared the ground for tighter U.S. policy. With two of the world’s most powerful central banks moving in the opposite directions, investors will be caught in the middle.
The risks include big shifts in global money flows that could drive U.S. interest rates higher or lower and cause financial disruptions that undo both central banks’ efforts.
The BOJ on Wednesday opened the monetary spigots further, essentially saying it would try to control the market for long-term bonds that is normally ruled by investors. That is a switch from its previous strategy of buying a fixed amount of government bonds at any price.
It also amped up its rhetoric about inflation, which it has failed to ignite. The BOJ said that it now aims to overshoot rather than just meet its 2% target.
The Fed, the BOJ and Markets
Specifically, the BOJ’s move to target the yield on 10-year bonds at around 0%—above where the debt has traded recently—alters the calculus for investors and could further distort bond, stock and foreign-exchange markets. There is no longer a willing buyer, but a price setter.
The aim here is to keep even longer-term rates in positive territory, providing relief for pension funds, banks and insurers from low long-term rates. That wasn’t lost on investors Wednesday, with shares of Japanese financial institutions rising 6% on average.
Yet the consequences of this foray deeper into experimental territory remain unknown and the goal of reviving inflation as distant as ever. Particularly in the context of a global economy that, as the Organization for Economic Cooperation and Development put it on Wednesday, remains in a “low-growth trap.”
Meanwhile, the Fed sent a strong signal that it expects to raise rates by December. The statement it released following its two-day meeting on Wednesday said that case for a rate increase had “strengthened,” while its projection materials show that all but three of the 17 meeting participants think the midpoint of its target range should be at least a quarter-point higher by year end. And three voting members of the Fed’s policy-setting committee—an unusually large number—dissented in favor of raising rates.
Despite its apparent intentions, whether the Fed will actually follow through with a tightening remains an open question. Given its belief that tightening too soon is far more dangerous than waiting too long, it might not take much for the central bank to rethink its plans. Indeed, futures on Wednesday put the odds of a rate increase by December at a bit above 50%.
Both central banks’ policy plans present risks to markets. One in Japan is that all of the BOJ’s meddling on the yield curve actually makes it less stable, or encourages investors test the bank’s resolve or try to go around it by driving up parts of the market the bank isn’t trying to control.
In the U.S., investors may not be taking the Fed’s intentions seriously enough, repeating the mistake they made ahead of last year’s rate increase, putting them in danger of getting caught wrong-footed.
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But the bigger risks may stem from two of the world’s major central banks trying to do very different things at the same time.
The BOJ’s targeting of long-term Japanese government bond yields, for example, will alter Japanese investors’ appetite for U.S. Treasurys — and will therefore influence long-term interest rates in the U.S. The Fed’s plan to raise short-term rates at the same time that the BOJ, through its commitment to overshoot its inflation target, is signaling it will keep short-term rates negative for a very long time, could shift global money flows in other ways.
Both the Fed’s caution and the BOJ’s modest shift in strategy show how central banks have become humbled in markets that they used to rule. Investors seem to have more confidence, driving stock and bond markets to new highs.
If the lenders of last resort are worried, investors should be too.