Wary Fed has markets recalling years of Japan disappointment

Fri Sep 18, 2015 12:54pm EDT
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By Jamie McGeever and Patrick Graham

LONDON (Reuters) - If Japan's experience in the 1990s is anything to go by, central banks that serially disappoint market expectations of higher interest rates will soon see those expectations fall to zero.

Financial markets were unnerved by the Federal Reserve's decision on Thursday to hold interest rates close to zero despite weeks of speculation that it was about to raise them for the first time in almost a decade.

Their concern is that if the global economic cycle is turning lower with rates still at emergency settings aimed at easing the pain of the last recession, then central banks may be trapped at zero with no ammunition to cope with a new downturn.

For all the caveats about different circumstances, investors are again looking to Japan's experience of 20 years ago for an inkling of what's going on now in the major Western economies.

Market behavior in the four years after the Bank of Japan first experimented with near-zero borrowing costs in 1995 tells a sobering tale: The economy sank into a cycle of falling wages, prices and output from which it has still not emerged, a specter that has haunted policymakers across the developed world since the 2008 financial crisis.

Three times in 1996 and 1997, measures of 3-month forward interest rates in Japan rose above 1 percent only to sink back to levels below 0.5 percent, which reflected effectively zero borrowing costs.

In the three years that followed, those blips - even supported by a short-lived quarter-point hike in official rates - slipped steadily lower before flatlining for five years around 0.1 percent.

The Fed and others like the Bank of England and European Central Bank may not be in that territory yet, but the lessons from Japan are clear: The longer rates are anchored at zero, the more financial markets sense the difficulty the central bank faces in raising them much, if at all.   Continued...

Traders work underneath a television screen showing Federal Reserve Chair Janet Yellen announcing that the Federal Reserve will leave interest rates unchanged on the floor of the New York Stock Exchange in New York September 17, 2015.  REUTERS/Lucas Jackson