Household Portfolios in a Secular Stagnation World

A recent working paper from the Bank of Japan paints a concerning picture of how households react to an economy in stagflation and offers important insights relevant to other economies struggling with similar economic conditions. Their modelling suggests that persistently low interest rates damage the wealth of savers and compresses the wealth distribution. In a low interest rate/low growth environment, households tend to invest less in stocks and shares, or business ventures, and tend to hold more of their savings in cash deposits (even at low or zero rates). In other words, economic growth in suppressed further, in a feedback loop, thus sustaining stagflation for longer (and in our view tending to create conditions which become impossible to escape from – and cutting rates into negative territory will not offer an escape path).

Japan experienced a stock market boom (bust) in the 1980s (1990s) followed by a financial crises. The Bank of Japan’s response to the collapse of the bubble and subsequent deflation is an early version of the kinds of quantitative easing programs now pursued by other major central banks. Despite this policy stimulus, Japan has gone through two decades of low growth, low interest rates and low inflation.

In this paper we set out to understand the way these macroeconomic events affected Japanese household financial decisions.  This is interesting because the Japanese experience can provide some indication of how the developed world may be affcted by the onset of such a ‘secular stagnation’ episode characterised by persistently weak rates of inflation and economic growth.

Using data from the Japanese Survey of Household Finance (SHF) from 1981 to 2014, we start by documenting several key household portfolio facts that are unique to Japan. First, stock market participation is considerably lower than in the US: in 2014, 15.5% of all households participate in the stock market. Second, conditional on participation, stockholders hold a relatively small share of wealth in stocks as a percentage of total financial wealth, and a relatively large share of financial wealth in bonds and money. Third, whether one focusses on stockholders or non-stockholders, the share of wealth allocated to cash-like financial instruments is very high. For instance, even for stockholders the share of liquid bank accounts in total financial assets is between 20% and 40% (depending on the age group). Fourth, the gap between the
average wealth of stockholders relative to that of non-stockholders is much smaller in Japan than in the US.

What can account for these facts? To answer this question we rely on counterfactual analysis based on a structural, quantitative, life-cycle portfolio choice model with an explicit role for inflation and money demand. Understanding money demand is essential to match Japanese household portfolios given the strong prevalence of money-like financial instruments in Japanese portfolios. Portfolio choice models that incorporate monetary assets are not readily available. Instead, we make explicit the choice between money (that earns a zero nominal return) and other assets like bonds and stocks that earn the historically observed rates of return.

Given that our purpose is to develop a tractable, quantitative, model that can be confronted with the data, we introduce money demand through the shopping time approach. Specifically, we assume that money provides liquidity services: a higher amount of money lowers the cost from having to undertake a given transaction for consumption purposes. Everything else we assume is similar to recent life-cycle models that feature intermediate consumption and stochastic uninsurable labor income.

We calibrate the structural parameters of the model by matching key data moments from the Japanese Survey of Household Finances. Using fixed costs of stock market entry and preference heterogeneity, the calibrated model matches quantitatively limited stock market participation, and the share of wealth in money, bonds and stocks over the later parts of the life cycle. Understanding the portfolio choices associated with that part of the life cycle becomes extremely important in counterfactual analysis as most wealth accumulation takes place at that stage of the life cycle. Armed with this model we can now run counterfactual experiments to better understand the key drivers of Japanese household portfolios. Our counterfactual analysis can informatively address our key questions: why do Japanese households hold so few stocks and such high money balances?

Perhaps the single most widely discussed aspect of Japan’s economic performance since 1990 has been its persistently low level of inflation which has averaged close to zero for almost 15 years. It has been argued that a low level of inflation encourages investors to hold nominal assets (such as money) rather than real assets (such as equities). Our counterfactual experiments confirm this intuition. Had inflation in Japan averaged 2% (as in the US) stock market participation would have risen from 15.3% in the baseline simulation to around 20%. Moreover, the share of stocks in young and middle aged stockholders’ portfolios would have been significantly higher mainly at the expense of lower money holdings, while the share of stocks in elderly households’ portfolios would remain unaffcted . Therefore, low inflation plays an important role in keeping the share of money in Japanese household financial assets very high and contributes to crowding out stocks and bonds from household portfolios.

The second legacy of Japan’s long stagnation since 1990 has been its poor history of realized (and plausibly expected) stock returns as compared to other countries. In the baseline calibration, the mean equity premium for Japan is set to 1.8%. Increasing this to 4% (a typical choice in many life-cycle models calibrated to US data) raises the mean financial wealth to income ratio substantially and increases the stock market participation rate to 50%, a rate that is very close to the recent US experience.

Another important feature of the calibrated structural model is the relatively high cost of stock market entry. Reducing this fixed cost from our estimate (9%) to 5% (as estimated for the US in the literature) leads to an increase in the stock market participation rate from 15.3% to 43% indicating that frictions in equity market participation can be a very important factor in limiting Japanese households’ investment in equities.

The final interesting aspect of the Japanese household portfolio data is the puzzling low mean wealth of stockholders relative to non-stockholders at least in comparison with the US Survey of Consumer Finances (SCF). As before, low realized (and expected) stock returns play an important role in explaining this fact. Returns to capital (the stock market) have important long term implications for the wealth distribution. In the US, realized equity returns have been high, benefitting stock owners. In Japan, by comparison, realized stock returns have been low, and the wealth of those who own stocks relative to those who do not, has not risen to the same extent, generating lower wealth differences. This is especially interesting given the finite nature of the life cycle: one need not rely on an infinite horizon model to generate substantial differences in the wealth distribution. Moreover, these substantial wealth differences can arise even from a relatively low mean differential in expected stock returns (2%).

Note that papers in the Bank of Japan Working Paper Series are circulated in order to stimulate discussion and comments. Views expressed are those of authors and do not necessarily reflect those of the Bank.

Bank of Japan Keeps Rates Steady

In their statement of monetary policy, the Policy Board of the Bank of Japan said that Japan’s economy has continued its moderate recovery trend, although exports and production have been sluggish due mainly to the effects of the slowdown in emerging economies.

Overseas economies have continued to grow at a moderate pace, but the pace of growth has somewhat decelerated mainly in emerging economies. In this situation, the pick-up in exports has recently paused. On the domestic demand side, business fixed investment has been on a moderate increasing trend as corporate profits have been at high levels. Against the background of steady improvement in the employment and income situation, private consumption has been resilient. Meanwhile, the pick-up in housing investment has recently paused and public investment has been on a moderate declining trend, albeit remaining at a high level. Reflecting these developments in demand both at home and abroad, industrial production has continued to be more or less flat. Financial conditions are highly accommodative. On the price front, the year-on-year rate of change in the consumer price index (CPI, all items less fresh food) is about 0 percent. Although inflation expectations appear to be rising on the whole from a somewhat longer-term perspective, they have recently weakened.

With regard to the outlook, although sluggishness is expected to remain in exports and production for the time being, domestic demand is likely to follow an uptrend, with a virtuous cycle from income to spending being maintained in both the household and corporate sectors, and exports are expected to increase moderately on the back of emerging economies moving out of their deceleration phase. Thus, Japan’s economy is likely to be on a moderate expanding trend. The year-on-year rate of change in the CPI is likely to be about 0 percent for the time being, due to the effects of the decline in energy prices, and, as the underlying trend in inflation steadily rises, accelerate toward 2 percent.

Risks to the outlook include uncertainties surrounding emerging and commodity-exporting economies, particularly China, developments in the U.S. economy and the influences of its monetary policy response to them on the global financial markets, prospects regarding the European debt problem and the momentum of economic activity and prices in Europe, and geopolitical risks. Against this backdrop, global financial markets have remained volatile. Therefore, due attention still needs to be paid to a risk that an improvement in the business confidence of Japanese firms and conversion of the deflationary mindset might be delayed and that the underlying trend in inflation might be negatively affected.

The Bank will continue with “Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest Rate,” aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner. It will examine risks to economic activity and prices, and take additional easing measures in terms of three dimensions — quantity, quality, and the interest rate — if it is judged necessary for achieving the price stability target.

With a view to implementing “QQE with a Negative Interest Rate” smoothly, the Bank decided on operational details. Namely, (1) each financial institution’s “Macro Add-on Balance,” to which a zero interest rate is applied, will be reviewed every three months in principle; (2) in light of the role of money reserve funds (MRFs) in fund settlement for securities transactions, the amount outstanding of MRFs entrusted to a trust bank will be added to its Macro Add-on Balance (up to the amount outstanding of MRFs entrusted to this trust bank during the previous year); and (3) with the aim of further supporting financial institutions’ efforts to increase lending, in case where a financial institution increases the amount outstanding of borrowing from the Bank through the Loan Support Program and the Funds-Supplying Operation to Support Financial Institutions in Disaster Areas affected by the Great East Japan Earthquake, twice as much as the amount of increase will be added to this financial institution’s Macro Add-on Balance.

They also provided details on some of their planned operations:

(1) Quantity Dimension: The guideline for money market operations The Bank decided, by an 8-1 majority vote, to set the following guideline for money market operations for the intermeeting period: The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 80 trillion yen.

(2) Quality Dimension: The guidelines for asset purchases With regard to the asset purchases, the Bank decided, by an 8-1 majority vote, to set the following guidelines: a) The Bank will purchase Japanese government bonds (JGBs) so that their amount outstanding will increase at an annual pace of about 80 trillion yen. With a view to encouraging a decline in interest rates across the entire yield curve, the Bank will conduct purchases in a flexible manner in accordance with financial market conditions. The average remaining maturity of the Bank’s JGB purchases will be about 7-12 years. b) The Bank will purchase exchange-traded funds (ETFs) so that their amount outstanding will increase at an annual pace of about 3 trillion yen until the end of March 2016 and, from April, at an annual pace of about 3.3 trillion yen.1 It will also purchase Japan real estate investment trusts (J-REITs) so that their amount outstanding will increase at an annual pace of about 90 billion yen. c) As for CP and corporate bonds, the Bank will maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively.

(3) Interest-Rate Dimension: The policy rate The Bank decided, by a 7-2 majority vote, to continue applying a negative interest rate of minus 0.1 percent to the Policy-Rate Balances in current accounts held by financial institutions at the Bank.

Japan Goes For Negative Interest Rates

In a surprise decision, the Bank of Japan (BoJ) has announced a policy of negative interest rates in an attempt to boost the country’s flagging economy.

“At the Monetary Policy Meeting held today, the Policy Board of the Bank of Japan decided to introduce “Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest Rate” in order to achieve the price stability target of 2 percent at the earliest possible time. Going forward, the Bank will pursue monetary easing by making full use of possible measures in terms of three dimensions; quantity, quality, and interest rate”.

In a 5-4 vote, the Bank of Japan’s board imposed a 0.1% fee on deposits left with the Bank of Japan, effectively a negative interest rate, from the reserve maintenance period, which commences from February16, 2016.

The authorities hope negative interest rates will encourage commercial banks to lend more to promote investment and growth, and drive inflation higher. Latest data showed that Japan’s inflation rate came in at 0.5% in 2015, well below the BoJ’s 2.0% target.

This experiment takes Japan into new and uncharted territory.

“Japan’s economy has continued to recover moderately, with a virtuous cycle from income to spending operating in both the household and corporate sectors, and the underlying trend in inflation has been rising steadily. Recently, however, global financial markets have been volatile against the backdrop of the further decline in crude oil prices and uncertainty such as over future developments in emerging and commodity-exporting economies, particularly the Chinese economy. For these reasons, there is an increasing risk that an improvement in the business confidence of Japanese firms and conversion of the deflationary mindset might be delayed and that the underlying trend in inflation might be negatively affected”.

The Bank will adopt a three-tier system in which the outstanding balance of each financial institution’s current account at the Bank will be divided into three tiers, to each of which a positive interest rate, a zero interest rate or a negative interest rate will be applied, respectively.

1. The Three-Tier System
(1) Basic Balance: a positive interest rate of 0.1 percent will be applied With regard to the outstanding balance of current account at the Bank that each financial institution accumulated under QQE, the Bank will continue to apply the same interest rate as before. The average outstanding balance of current account, which each financial institution held during benchmark reserve maintenance periods from January 2015 to December 2015, corresponds to the existing balance and will be regarded as the basic balance to which a positive interest rate of 0.1 percent will be applied.
(2) Macro Add-on Balance: a zero interest rate will be applied A zero interest rate will be applied to the sum of the following amounts outstanding.
a) The amount outstanding of the required reserves held by financial institutions subject to the Reserve Requirement System
b) The amount outstanding of the Bank’s provision of credit through the Loan Support Program and the Funds-Supplying Operation to Support Financial Institutions in Disaster Areas affected by the Great East Japan Earthquake for financial institutions that are using these programs c) The balance calculated as a certain ratio of the amount outstanding of its basic balance in (1) (macro add-on). The calculation will be made at an appropriate timing, taking account of the fact that the outstanding balances of current accounts at the Bank will increase on an aggregate basis as the asset purchases progress under “QQE with a Negative Interest Rate.”
(3) Policy-Rate Balance: a negative interest rate of minus 0.1 percent will be applied A negative interest rate of minus 0.1 percent will be applied to the outstanding balance of each financial institution’s current account at the Bank in excess of the amounts outstanding of (1) and (2) combined.

Also, the Bank decided, by an 8-1 majority vote, to set the following guideline for money market operations for the intermeeting period. The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 80 trillion yen.

“a) The Bank will purchase Japanese government bonds (JGBs) so that their amount outstanding will increase at an annual pace of about 80 trillion yen.3 With a view to encouraging a decline in interest rates across the entire yield curve, the Bank will conduct purchases in a flexible manner in accordance with financial market conditions. The average remaining maturity of the Bank’s JGB purchases will be about 7-12 years.
b) The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding will increase at annual paces of about 3 trillion yen4 and about 90 billion yen, respectively.
c) As for CP and corporate bonds, the Bank will maintain their amounts  outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively”.