The market consequences of exiting Japan’s liquidity trap
The moves in Japanese currency and equity markets have been the single biggest change in the
macro landscape over the last few months. Markets have clearly responded to shifts in the
Japanese monetary policy framework and are anticipating further shifts ahead.
Judging the opportunities from here requires two things:
 First, a view on how policy is likely to change; Naohiko Baba and our Japan Economics
team have laid out the possible options for monetary policy in the months ahead, and
continue to discuss and monitor the operational challenges for delivering fresh easing
(see Japan Economics Analyst 13/01, for example).
 Second, a view on the shifts that markets are already expecting. That task is
complicated by the counterintuitive nature of how markets behave in liquidity traps. To
escape the trap, Japan needs to raise inflation expectations to lower real rates, since
nominal rates cannot be lowered. That is the logic behind the shift in monetary policy
and a 2% inflation target.
We look here at what a successful exit from the liquidity trap should look like and some simple
ways to monitor and benchmark progress towards that. The combination of stable nominal bond
yields, a weakening currency and rising equities is fully consistent with the start of that process.
The decline in real rates and the rise in inflation expectationswhich we also extract from longdated
currency forwardsdefy the notion that we have ‘seen this all before’. Whether
policymakers ultimately succeed in validating expectations, the shift in markets on this front is
genuinely new. But a fully credible 2% inflation targetif it can ever be achievedwould
potentially involve much larger shifts.
Liquidity traps–Ginza style
Liquidity trapsthe point at which conventional monetary policy becomes ineffective because
nominal interest rates fall below zerohave become a common feature of the landscape in the US,
UK and other major economies. But Japan remains the archetype, and a cautionary tale. It is the
first case in modern historyand so the longest-lastingof an economy coming hard up against the
zero bound. But it is also the only case so far where a slide into deflation has meant that real interest
rates (the nominal rate less expected inflation) are positive even with rates at zero. Unlike the US,
where the market still prices an eventual exit, Japanese rates markets have long priced policy to be
stuck effectively at zero into the indefinite future. As a result, unlike the US, the ability to influence
even long-term nominal interest rates through asset purchases has largely been exhausted. Raising
inflation expectations is the only plausible channel to shift the real rate structure.
While Japan first slid into deflation 15 years ago, the constraints of the liquidity trap intensified
with the 2008 financial crisis. The classic symptoms of a liquidity trapreal rates that are too high
and a real exchange rate that is too stronghave been starkly visible since then. Where the Fed
offset deflationary pressures through sharp falls in long-term nominal and real interest rates,
Japan’s long-term real interest rates rose through the crisis and stayed above pre-crisis levels
from mid-2008 through 2012 (Exhibit 1). The impact was compounded by the sharp reductions in
interest rates in the US and elsewhere. The real interest rate differential between the US and
Japan swung from positive to negative in late 2008 and moved further as the Fed’s
unconventional policies lowered US real rates further in 2011, without a sufficiently aggressive
offsetting BoJ response. As a result, the JPY strengthened during the crisis and strengthened
more through the recovery (Exhibit 2).