Despite slowing inflation, the Bank of Japan has thus far this year limited itself to a few small, preparatory policy adjustments, and may yet again disappoint investors by keeping its wait-and-see approach until after the potentially disruptive US presidential election. But what remains clear is that, despite claims to the contrary, the BOJ is not running out of policy ammo.
The main problem with the frequently articulated claim that the BOJ is running out of ammunition in its fight against deflation is that it is putting the cart before the horse: inflation in Japan is not receding because of a depleted arsenal of tools, but because the BOJ has for the time being chosen to largely ignore the commodity price collapse, as well as the subsequent surge in the yen. To be fair, while time is gradually running short, it might still be proven right in the end. The following facts illustrate that point.
Firstly, the BOJ has once before patiently allowed inflation to retreat to about the same level as today, before surprising markets with a big expansion of its “qualitative and quantitative easing” program in October 2014. Back then, during the preceding nine months, Japan’s inflation had also slowed significantly, as the crude oil price plunged by about 50% in yen terms. But inflation quickly recovered after the BOJ decided to ease policy - even as oil dropped by another 50% over the year that followed (see chart 1, page 2). With this broader picture in mind, it is not too difficult to see why the BOJ was not in a big rush to act this time around as well. It knows that it can always intervene if it wants to, and that its tools can have a massive impact on markets (charts 2 and 3, page 2).
This point is important because of the potential similarity with the transitory impact of yen’s 25% surge against a basket of nine major currencies since December, which depressed inflation again. But once the BOJ acts and the initial negative effect of the strong yen starts to fade, inflation could very well return again. Moreover, Japan’s undistorted core inflation (which excludes the one-off impact of the 2014 value added tax on consumption hike) has remained remarkably stable, given the circumstances - after having soared by more than 2 percentage points since the start of Abenomics, as Japan’s reflationary campaign is known.
Secondly, while Japanese equity indices have been underperforming this year, Japan still ranks among the best-performing markets from a five-year perspective, i.e. roughly since the political start of Abenomics (see page 4). This too justifies the BOJ’s wait-and-see stance to some extent. Although policy action to revive market momentum now seems necessary at some point, Japan’s central bank, being more patient than most investors, may be viewing the recent stock market weakness as transitory.
In the meantime, BOJ Governor Haruhiko Kuroda, speaking at the central bankers’ symposium in Jackson Hole this past weekend, has explicitly confirmed that the BOJ will not hesitate to expand all “three dimensions” of QQE - meaning that it is willing to (1) boost the quantity of its asset-purchases, (2) add new types of assets to its program, and (3) take interest rates even deeper into negative territory. Among several options, for example, it is reasonable to expect the BOJ to start buying so-called Zaito bonds, issued by public agencies mandated to fund infrastructure and welfare programs, such as housing. These bonds are not formally guaranteed by the government. Their inclusion in the QQE program could thus also allow the BOJ to bypass a rule against directly funding public spending - if this were to prove a real political problem.
The only real question thus is: when will the BOJ decide act? As things look now, if market conditions remain as benign as in recent months, the BOJ seems to be quite willing to continue to wait until after the US presidential in early November.
Note: The next LGT Beacon will be published on 14 September 2016.