Bank of Japan’s Dilemma

As at 13 July 2023

Whereas the rest of the world’s central banks battle with persistence of higher inflation, Bank of Japan (BoJ) is concerned about whether inflation will land in a year and half’s time north of its 2% inflation target. Headline Consumer Price Index (CPI) has peaked in January at 4.3% Year-on-Year (YoY) and since came down to 3.2% (YoY), but core CPI (which excludes fresh food and energy prices) continued to grind higher and reached 4.3% (YoY) in the most recent May release. The May wage data showed stronger than expected growth at 2.5% (YoY) versus Bloomberg consensus of 1.2%. In addition, the final round of the spring Shunto wage negotiation ended with a base pay wage hike of 2.12%, much higher than last year’s 0.61%. The upside bias in wage inflation, solid activity data, and broadening price pressures all point to inflation staying higher into next year.

Source: Fulcrum Asset Management 

Our internal modelling is consistent with this view. To forecast inflation, Fulcrum uses an ensemble of econometric and statistical models, where different methodologies are averaged to produce a combined forecast. Model averaging has shown to outperform any individual model used for forecasting inflation. The Fulcrum forecast effectively captured the persistence of inflation over the last few years, making it informative about the future inflation outlook. The model forecasts suggest that headline inflation will be above the 2% target by May next year and stay consistently above thereafter.

The moment has come for the BoJ to decide when and how to wean the country off its ultra-loose monetary policy as inflation expectations have risen significantly over the past year. BoJ adopted the Yield Curve Control (YCC) policy in 2016 after more than two decades of persistent low inflation and disinflation. By purchasing Japanese government bonds (JGBs), the Bank kept the ten-year JGB yields at a target of “around zero percent” and vowed to continue the policy until inflation had moved above its 2% target “in a stable manner”. The upcoming meeting at the end of July is an opportunity for the BoJ to reassess and adjust the policy as the market watches keenly for any signs of normalisation.

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