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 behaviour 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 spectre 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.
"Japan is the eternal mistake," said Ashraf Laidi, CEO at Intermarket Strategy Ltd, arguing that the Fed's delay in raising rates on Thursday adds to a growing sense of correlation.
"People were continuously wrong about Japan," he says. "The Fed might get away with one rate hike or two, but it is (also) probably going to be forced to stay with lower rates for longer."
In March last year fed funds futures <0#FF:> were fully discounting a first rate hike by the second quarter of this year, a fed funds rate of 1 percent by the end of this year and 1.5 percent by the middle of next.
As recently as May this year, "liftoff" by the end of 2015 was fully priced in.
Expectations of a move had faded somewhat by the time the Fed held fire on Thursday, but it was still by far the closest call in years. The expected timing of the first hike based on fed funds futures has now been pushed back to next year.
"There's a continual series of expectations that a central bank will be able to move, and those are continuously pushed back ... but the target stays flat or moves lower," said Andrew Milligan, Head of Global Strategy with UK-based asset manager Standard Life (LONDON:SL) Investments.
Based on fed funds futures contracts, the first rate rise is now only 50 percent factored in by next January and 75 percent priced in by April.
Across the Atlantic, there was more evidence of pushback. Bank of England chief economist Andy Haldane said its next move could even be a cut in rates, not an increase, noting that the balance of risks to UK growth and inflation "is skewed squarely and significantly to the downside".
That underlines central banks' concern that non-existent inflation may yet morph into outright deflation, despite zero interest rates and the masses of liquidity coursing through the financial system courtesy of quantitative easing.
"Maybe it is denial that has kept markets from talking about it, but stagnation should be on the hymn sheet," said Tobias Davis, a corporate hedging manager with money transfer giant Western Union in London.
"I fail to comprehend how flat/falling U.S. inflation coupled with deteriorating external factors is an argument to hike rates. We are doing well to fend off deflation."