Times have changed since the West regarded Japan as a futuristic economy possibly about to overtake the US, but now the country looks like the future for a different reason: with its exceptionally loose monetary policy, it is several steps ahead of where other developed countries appear to be heading.
Western pessimists talk of “Japanification”, but this term implies that Japan’s monetary policy is somehow a fixed state to be reached. It is not: it must evolve amid renewed global growth fears and domestic pressure. How well it will be able to do so is unknown.
Amid the doom and gloom, it is easy to forget that Japan looks to have grown quite strongly in the first half of the year: by 0.6% in the first quarter and by 0.4% in the second (estimated on a preliminary basis).
“People’s forecasts are gradually being forced up in an environment where in the rest of the world everything is getting ratcheted down,” says James Malcolm, chief Japan economist at UBS in London.
Aside from global growth, the incoming rise in consumption tax is preoccupying Japan-focused economists. The rise from 8% to 10% is set to go ahead on October 1, after being delayed twice. While it is accompanied by offsetting measures, it is expected to dent demand.
Weak consumer sentiment after the introduction of the tax could well lead to two consecutive quarters of economic contraction across the turn of the year and force the government to turn on the spending taps, according to Yujiro Goto, head of FX strategy, Japan, at Nomura in Tokyo.
However, compared with the previous hike, the amount of frontloading in household spending “is likely to be limited”, according to a Bank of Japan report from July. This suggests it might not fall too much afterwards.
“There is still good reason to think that the drag won’t be as big as after the last two tax hikes,” says Marcel Thieliant, senior Japan economist at Capital Economics in Singapore.
Elsewhere, a spat between Japan and South Korea is also causing unease. It originated from a Korean court ruling against Japanese firms relating to wartime forced labour, and has now spread to trade policy. Japan has restricted exports of certain chemicals and removed South Korea from its exports “white list”.
“[President Shinzo] Abe’s playing a dangerous game, I’m not sure where it’s going to end up,” says Thieliant.
However, the short-term economic impact is likely to be muted. While ordinary Koreans have reportedly been boycotting Japanese imports, Thieliant notes that consumer goods make up a small proportion of the country’s exports to South Korea, while Korean firms cannot easily replace what they import from Japan.
Pressure to ease
Although the economic picture in Japan is not catastrophic, analysts think governor Haruhiko Kuroda’s Bank of Japan is likely to ease conditions at its next monetary policy meeting on September 18 and 19. The timing of it gives it a chance to react to September’s meetings of the US Federal Reserve and the European Central Bank.
“The hope had been that the external situation would be improving around the middle of year and you’d get this immaculate transformation where the external environment picks up the slack from the domestic environment and everything would net off very nicely,” says Malcolm. “But what’s clearly not happened is improvement on the trade war side, so those external risks have grown, which pushes back the whole notion of recovery and leaves you more vulnerable.”
An alternative view comes from Thieliant, who thinks the central bank could well wait for concrete evidence of economic weakening, which may come in only after the tax hike. “Until then I think they will be very reluctant to ease even if exports are not doing well, as long as domestic demand is holding up.”
Beyond exports and domestic demand, one pressure to change policy is that the government 10 year bond yield has been trading below the central bank’s perceived target range of 20bp to -20bp. And this contributes to a flattening of the yield curve, putting pressure on financial firms.
“The 10 year yield has fallen sharply and the curve has flattened so much that they require additional action of some shape or form,” says Malcolm.
At the same time, the yen has been appreciating (see chart) as investors pile in to what they perceive as a global safe haven. This can put downwards pressure on inflation.
“If dollar-yen looks like it’s going to be structurally lower from here, i.e. the yen appreciating significantly, the Bank of Japan has to be wary of what that does to their main target variable, which is inflation,” says Malcolm. “Below 105 and particularly below 100, you start to get into a situation where FX affects expectations a lot more domestically and weighs on profits a lot more.”
However, Thieliant thinks that the yen would need to rise by 15%-20% more for the central bank to ease.
If easing looks likely, the question then turns to how to do it. Particularly if the central bank wants to avoid too much damage to the banking sector, which has been hammered by falling net interest margins.
“The Bank of Japan’s view is that the side effects of loose policy on the banking sector build up cumulatively, so the longer you keep policy loose the bigger the side effects,” says Thieliant.
One option for the Bank of Japan would be to accompany a rate cut with a new lending scheme at negative rates for the banks. “Our understanding is that the BoJ has been increasing dialogue with banks in recent weeks hypothetically around these kind of issues,” says Malcolm.
However, the banks may not be the priority.
“Some on the [policy] board say: ‘Leave the banks to stew, there’s too much capacity, it’s a structural issue, there’s nothing that monetary policy can do. If anything, stimulative policy helps the economy generally and therefore indirectly supports banks much more than if you directly tried to help them by keeping front end rates higher,’” says Malcolm.
Focus on fiscal?
Perhaps the smallest change would be extending forward guidance out beyond next spring. Would this be enough? “Just extending forward guidance will suggest that the Bank of Japan has no policy options so markets see that the BoJ cannot do anything further,” says Goto. “That’s quite risky.”
As for the 10 year yield target, could a change be in order? Freya Beamish, chief Asia economist at Pantheon Macroeconomics, said in a recent note that Kuroda could overlook the breach of the target range. She is less convinced than some other analysts that the Bank of Japan will do much in the way of easing.
“Most likely, the statement will simply ignore the reality,” she wrote. “It’s possible, however, that he could explicitly widen the band around the target, to signal that it is not completely out of sync with central bank moves elsewhere.”
Then there is the option of a short-term interest rate slash. A cut from the current level of -10bp would help steepen the yield curve. Malcolm thinks that around -50bp would be the absolute limit for where the policy rate could go before it starts becoming contractionary as opposed to expansionary.
He thinks steepening the curve may not require too much work. “You can support the back-end of the yield curve if the market has more belief in reflation. If you can convince the market that what you’re doing is going to be effective, you probably don’t need to do very much.”
Weighing on the Bank of Japan’s mind might be its experience of cutting rates in January 2016. Afterwards, equity markets cratered and the yen shot up, although this was also a rough period for markets around the world, at a time of fears about global economic growth.
Of course, different options — like short-term rates, the 10 year yield target, forward guidance and quantitative easing — are not mutually exclusive. The Bank of Japan may decide that a variety would work best. “They recognise there’s not a lot of scope in any of those items individually,” says Malcolm. “Their idea is if you combine them, you can create some offsets, you can create a synergistic effect between them.”
How Japan decides to react in the coming months is of interest to the rest of the world’s economists, given those Japanification fears. But, after years of focus on central bank moves, perhaps fiscal policy could now come into the spotlight.
“In the current Japanese environment, there is a strong case for continuing to run primary deficits, perhaps even to increase them and to accept a higher debt level,” wrote Olivier Blanchard and Takeshi Tashiro, fellows at the Peterson Institute for International Economics, in May. “Primary deficits help sustain demand and output, alleviate the burden on monetary policy, and can increase future output. In short, the costs of primary deficits are small, and the costs and risks of high debt are low.”
While Japan has an exceedingly high gross debt to GDP ratio of about 235%, its borrowing costs are light and inflation remains stagnant.
“If the government were to say: ‘We will increase spending every year by 5% or 10% until we get to the 2% inflation target,’ that’s an environment in which I think you would change market expectations very quickly,” says Malcolm. “And that would have global implications.”
The sceptical view of global central bank easing says that Japan is out of bullets. But there might be another caseload of ammunition marked “fiscal policy” to open up.