Japan Ups the Ante in War on Deflation


Bank of Japan (BOJ) Governor Haruhiko Kuroda has pulled another rabbit out of the hat with his latest policy trick. Can Japan’s central bank finally win the war against deflation without going bust in the process?

Declaring Wednesday that Japan’s economy “is no longer in deflation,” the BOJ nevertheless admitted that its policy of aggressive quantitative easing (QE) had failed to change mindsets among a deflation-weary populace.

The latest benchmark gauge of Japan’s consumer prices dropped by 0.5 percent in July from a year earlier, well below the 2 percent target sought by the BOJ. It blamed falling crude oil prices, the 2014 consumption tax hike, and a slowdown in emerging economies along with volatile global financial markets for the stubbornly low inflation expectations.

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This required yet more policy innovation and the central bank did not disappoint, adding “yield curve control” along with an “inflation-overshooting commitment” to measures aimed at reaching its target.

By a majority seven to two vote, the BOJ’s policy board decided to continue its short-term negative interest rate of minus 0.1 percent, but adjust the long-term rate by purchasing Japanese government bonds (JGBs) to ensure 10-year JGB yields “remain more or less at the current level” at around zero percent.

The BOJ said it would maintain its record QE policy of buying 80 trillion yen ($794 billion) of JGBs, but scrapped its guideline for the average remaining maturity of its bond purchases as well as extending the longest maturity of its fixed-rate operations for up to 10 years.

It also decided to continue buying exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) at an annual rate of 6 trillion yen and 90 billion yen, respectively, as well as buying 2.2 trillion yen worth of commercial paper and 3.2 trillion yen worth of corporate bonds.

The BOJ said it would continue expanding the monetary base “as long as it is necessary” to achieve its target – a base so large that in a year it is expected to exceed 100 percent of nominal gross domestic product (GDP), or around 500 trillion yen, compared to the 20 percent ratio in the United States and Eurozone.

The bank said it would allow inflation to overshoot its price target to enhance credibility, with a goal of reaching 2 percent inflation “at the earliest possible time.” Other possible measures could include cutting the short-term policy rate further into negative territory, changing the target long-term rate or expanding asset purchases along with the monetary base.

“Our adjustments today make us more flexible [in dealing with economic shocks],” Kuroda said at a press conference after the meeting. “We’ve thus managed to raise the sustainability of our policy.”

Japanese financial markets responded favorably to the policy change, with the benchmark Nikkei Stock Average gaining 1.9 percent to 16,807, while the broader TOPIX index advanced by 2.7 percent to 1,352. The yield on the 10-year JGB also briefly rose above zero for the first time since March, while the yen eased against the dollar after previously hitting its lowest level since early September.

The new focus on the yield curve is also expected to ease the pressure on the nation’s financial institutions, with the negative interest rate policy having hit profits at banks, insurers, and pension funds. The BOJ also noted that “an excessive decline and flattening of the yield curve may have a negative impact on economic activity” by damaging “people’s sentiment” in the financial system.

According to The Wall Street Journal though, the new policy reflected a split among policy board members between those favoring centering policy on interest rates and others wanting to continue the record asset purchases.

“The winner was the interest-rate-targeting faction, and Wednesday’s action made clear that Kuroda himself was part of that faction. All that was left was to throw the losers a few bones by leaving in the 80 trillion yen number, at least on paper, and setting a more aggressive inflation target of exceeding 2 percent instead of just reaching 2 percent,” the newspaper’s Peter Landers claimed.

Stopping The Bond Rout

Other analysts suggested that the BOJ had avoided starting a global bond market sell-off, amid speculation that both the Japanese and European central banks had started running out of ammunition.

“One of the messages we take particularly out of what the BOJ has done is if there is to be a global sell-off in bond yields, it’s not going to be led by Japan,” Nikko Asset Management’s James Alexander told the Australian Financial Review.

Jesper Koll, chief executive of WisdomTree Japan, said Kuroda’s latest measures had confirmed the central bank’s desire for stronger banks, a steeper yield curve, a broader and stronger stockmarket, and a possible overshoot on inflation.

“The commitment to the 2 percent inflation target was actually strengthened – the board now explicitly seeks an ‘overshoot’ to the target. Clear speak – nobody is in any hurry to taper or roll back quantitative easing in Japan,” Koll said.

“The message could not be clearer: This is a positive for Japan equities, banks and financials in particular, and in my view, is negative for the yen.”

He added: “From here, a most interesting new challenge will come from the fact that the BOJ did not specify a numerical target for bond yields – a steeper curve is desired, but how steep is steep enough is not.

“Personally, I think this is good policy as it adds uncertainty; in coming weeks or months it will be interesting to see whether certain yield levels do start to trigger BOJ commentary. I have no doubt that markets will want to test where possible ‘pain-points’ may be for Governor Kuroda. However, for now, the JGB yield rose has room to run, in my view.”

‘BOJ Insolvent In 3-4 Years’

However, Japan analyst Naomi Fink, chief executive of Europacifica Consulting, said an end to ‘Kurodanomics’ was drawing nearer.

“The longer the policy continues, the greater the distortion inflicted upon financial markets. As the BOJ continues to buy vast amount of negative yielding government bonds, the central bank quickly turns itself into a loss making entity. Without alteration to its strategy, the BOJ may become insolvent in three to four years,” Fink warned.

“By early 2018, the BOJ will own equity assets thrice the size of its capital. A severe downturn in the equity market could wipe out the BOJ’s capital. While the government could replenish the capital, the consequent political and policy uncertainty is likely to inhibit the ability of the BOJ to credibly continue its QQE program.”

In its economic outlook commentary, the BOJ said the world’s third-biggest economy was continuing its “modest recovery trend, although exports and production have been sluggish” due to the slowdown in emerging economies, including neighboring China. While suggesting that a pickup was in sight once export markets “move out of their deceleration phase,” the BOJ noted risks including Brexit, China’s slowdown, and uncertainties over U.S. interest rates and European banks.

With the U.S. Federal Reserve leaving its target rate unchanged in its latest policy meeting, the focus has moved back to other policy tools that could revive inflation, including fiscal policy.

“Rather than explore the far reaches of unconventional policy, the better approach is to recognize the inherent limitations in monetary policy when given the task of stimulating the economy. Central bank governors, whether the Fed’s Janet Yellen or the BOJ’s Kuroda, should not claim too much power for their policy instruments,” Stephen Grenville, a former deputy governor of the Reserve Bank of Australia argued.

“With competence and some luck, central banks may be able to maintain inflation close to target in good times. But when the economy falls into a deep hole, monetary policy should not be expected to carry out the rescue alone.”

For Kuroda, the sooner “Abenomics” becomes the center of market attention, the better.

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