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Up Front

Fed Policy, Stock Markets and Japan

Douglas J. Elliott

The 6.4% fall in the Japanese stock market overnight, and the general retreat in global stock markets since late May, underline the importance of monetary policy for financial markets. There’s a reason for the old Wall Street saying that you should “never fight the Fed.” Monetary policy is a major determinant of economic activity and therefore of the value of the stocks and bonds of companies, since they are all affected by the level of economic growth. It also affects the cost of funding investment activities; lower interest rates make virtually all investments more attractive. Securities purchases by the Fed and other central banks around the world have a similar effect by bidding up prices. Further, the level of a country’s interest rates has a major impact on currency rates, with money tending to flow to where it can earn the highest interest and away from where it can be borrowed most cheaply. (The so-called “carry trade” focuses specifically on borrowing in currencies with cheap money and investing in currencies with higher interest rates.)

The Japanese are engaged in a massive exercise of monetary loosening in an attempt to increase asset prices and lower exchange rates in the anticipation that both factors will spur economic growth. This has led to sharply higher Japanese stock prices over the last half year, a gain that is being partially unwound as new doubts arise about how fully effective the new policies will be. The big question is whether this is (a) simply an adjustment to a more realistic view of policies that should remain quite supportive of the markets and economic growth or (b) a realization that the policy may be ineffective or ultimately counterproductive. I suspect that the answer is (a), but that the adjustment has further to go, since hopes have been quite inflated and there was insufficient recognition of the dangers and costs of the approach. That said, Japanese stock prices were massively beaten up over the last two decades and it may be that they are responding substantially to a reduction of an excessive and pervasive pessimism.

Markets around the world are also responding to the likelihood that the Fed will begin tightening monetary policy soon. For more on the implications of this, please see my recent presentation at an investor conference.