The Bank of Japan has introduced aggressive and unconventional measures to pull its economy away from deflation since 2013. Quantitative and qualitative easing has been unprecedentedly large for an advanced economy, and has broadened to include purchases of private sector assets, such as equity ETFs, as well as government bonds. But the strategy is once again running into severe problems with persistently low inflation.
Since April 2016, the easing has been bolstered by yield curve control, which has in effect fixed interest rates from the overnight rate to the 10-year government bond yield at very close to zero. This amounts to a promise from the central bank to purchase any amount of government debt that is needed to keep long term bond yields at zero, even if inflation begins to rise.
Actually, the scale of the official bond purchases has fallen as the yield cap became more credible in the markets, so QE is now running at about half of the original ¥80tn annual rate. However, this is not the best measure of the degree of stimulus being imparted by the strategy. If the policy mix succeeds in raising inflation, it will result in a deliberate cut in real interest rates, thus becoming ever more stimulatory over time.
The BoJ has appeared reasonably happy with its policy settings since 2016, and has consistently forecast that inflation will meet its objective of overshooting the 2 per cent target by the end of successive forecast horizons.
However, following the publication of several successive disappointing inflation results (see below), the Policy Board will enter its meeting on 30-31 July with a clear need to adjust its inflation projections downwards yet again. This time, they may also open a more significant debate on whether the monetary strategy should be altered to make it more sustainable.
The consumer price inflation data for June represented the third successive downside surprise. This was particularly disappointing, given the firmer data for Tokyo prices that had appeared earlier in the month. The national CPI figures showed that core inflation (ex food and energy) fell to only 0.2 per cent, barely in positive territory, and less than half the expected rate for June.
These low figures did not come as much of a surprise to Fulcrum’s inflation monitoring system, which has been suggesting that underlying inflation remain rather low. Underlying inflation is calculated from Stock and Watson (SW) trend models shown here:
Note that these underlying rates increased slightly after the initial monetary shock and devaluation introduced by Abe/Kuroda in 2012/13, but have since then remained stuck at close to zero, despite several attempts to ease monetary conditions further.
Our preferred inflation forecasts are produced from a combination of the SW underlying trends and a BVAR model that incorporates the exchange rate, oil prices and indirect tax effects. The latest forecasts suggest that the annual inflation rates will remain on a moderately downward path until early 2019, reflecting the latest drop in oil prices. By then, the headline rate could be around 0.5 per cent, with core inflation close to zero.
After that, the consumption tax increase due in October 2019 will increase headline and core inflation rates by about 0.8 per cent, but the 12-month change will probably disappear a year later. In any event, inflation in late 2019 will still be around a full percentage point below the central bank’s latest forecasts, a considerable miss.
A key reason why inflation remains stubbornly low is that inflation expectations in Japan seem to be driven largely by reported inflation data on a backward-looking basis. This has held wages down and flattened the Phillips Curve.
None of the indicators followed by the central bank to assess inflation expectations have risen in line with the official inflation target.
In the financial markets, five-year inflation swaps improved for a while as oil prices recovered in 2016-17, but this year the swap rates have been moving sideways, and have been running well below the BoJ’s objective of “above 2 per cent”, even in the longer term. Until this problem is fixed, very low inflation will probably persist.
The board is split. Members who are very concerned about the damaging impact of yield curve control on the capital of financial institutions and therefore on credit extension include deputy governor Masayoshi Amamiya, Hitoshi Suzuki and Takako Masai. Those who wish to press ahead with the current policy mix include deputy governor Masazumi Wakatabe, Yutaka Harada and Goushi Kataoka, with Governor Haruhiko Kuroda sitting firmly in the centre. The governor normally leans dovish but he needs to recognise increasing concerns among his colleagues about financial stability.
It is premature to expect any firm action in the July board meeting. Instead, the BoJ is likely to reduce its inflation forecast by about 0.4 per cent this year, and perhaps 0.6 per cent next year, postponing the date of 2 per cent plus inflation until fiscal year 2020 or even 2021. They are also likely to launch a “comprehensive review” of the degree to which yield curve control is working.
The results of the comprehensive review, which should emerge before the end of this calendar year, are unlikely to involve an unequivocal easing in the monetary stance, similar to those in previous years. Instead, the board will probably adopt a stance that makes yield curve control more “sustainable”, meaning that the principles of the strategy can be maintained indefinitely while relaxing the squeeze on the operating margins of the banking sector.
A likely change is to apply the controls to five year bond yields, while allowing ten year yields some scope to rise. Obviously, any jump in 10-year yields could confuse the markets, so clear communication of the central bank’s intentions — to keep overall financial conditions, including credit availability, as easy as possible until the 2 per cent plus inflation target is clearly in sight — will be crucial.
Even with very careful communication and forward guidance, monetary policy may not be sufficient, on its own, to reach the inflation target. Eventually, unconventional fiscal easing may also be needed, though this is not remotely on the horizon at present.