Like other major central banks, the BoJ has recently bumped up its growth forecasts and lowered its inflation estimates for this year and next. But while his peers at the Fed and (slowly but surely) the ECB have embarked on the path of policy normalisation, Governor Kuroda is nowhere near that point.

With air leaking out of the global reflation trade and yen hedging costs off last year’s highs, the market’s preoccupation with Japanese monetary acrobatics has diminished. Still, the theme of widening policy divergence is bound to come back in vogue in the not too distant future. Soft core inflation points to a relatively shallow path for interest rates in the US and the euro area but, after the recent bond rally, the risks for yields over the coming quarters are tilting to the upside again.

The Fed will soon start reducing its balance sheet and the ECB is on course to announce a recalibration of its asset purchase programme this autumn. As such, 2018 will probably find the BoJ holding the global QE baton alone. This should, in turn, bring yen weakness back squarely in investors’ sights. Could the BoJ finally get the inflation that it wants?

Four years into Abenomics, the BoJ can claim only partial success on the quantitative aspect of its unconventional policies. Aggressive JGB buying has driven real yields below the natural rate, ie the economy’s potential growth rate, which is itself down 0.15 percentage points since mid-2014 to just under 0.7%, according to BoJ estimates. Sustained deflationary pressures have been arrested, yet this is only half the job done. The Bank has failed on the qualitative part of QQE, namely engineering a sustainable rise in inflation expectations.

To this end, Governor Kuroda has gradually augmented QQE, first by introducing negative rates (NIRP) and subsequently yield curve control (YCC) plus a commitment to overshoot the 2% inflation target and “stay above the target in a stable manner”. Whether this constitutes a wise pledge is debatable but, at a minimum, it renders talk of an exit strategy premature for as far as the eye can see. On the positive side, YCC has enabled the BoJ to buy fewer JGBs. The bank has thus executed in effect a ‘passive taper’. This has alleviated the problem of JGB scarcity and allowed long yields to rise, thereby assisting domestic institutional investors in their search for duration. Yet inflation expectations remain subdued.

The Bank has suggested that the problem is largely psychological. Because Japan has been mired in deflation for so long, people tend to look back rather than ahead in setting their expectations for inflation, entailing an asymmetric reaction to inflation declines. But, as Ben Bernanke pointed out in a recent speech, reference to backward-looking expectations is less an explanation than a way of “restating the basic puzzle”. The BoJ’s credibility is stained by the well-publicised technical limitations of its bond buying, ie a forward-looking consideration. And, crucially, much depends on structural imbalances and factors outside the Bank’s direct control.

Fundamentally, achieving a sustainable transition to a superior growth/inflation trajectory is difficult for a mature economy like Japan’s. Given its shrinking population, weak productivity and chronically deficient domestic demand, falling price levels have been the main mechanism allowing real incomes to rise. What Japan needs is less profits and more wages, but the shift of income from business to labour remains elusive. Macro momentum is heavily reliant on a continued upswing in exports. Correspondingly, corporate sentiment is dictated by external, not domestic, reflationary dynamics that have also allowed the BoJ’s accommodative policies to evolve. Rising DM sovereign yields facilitated the introduction of yield curve control, allowing a ‘passive taper’ and yen depreciation to take place simultaneously while the world economy recovered.

Ironically enough, the BoJ is pushing all the ‘unconventional’ levers in its arsenal in order to engineer a ‘conventional’ outcome of export-led growth, spurred by currency weakness, that eventually pushes up wages and inflation. In the hope of raising inflation expectations, the Bank has pledged to overshoot the inflation target, which it expects to meet no earlier than FY 2019.

Looking ahead, the risk is that – just like with NIRP – the BoJ’s strategy backfires. NIRP caused financial side-effects that ended up driving the yen higher. Unless a meaningful pick-up in domestic demand allows monetary policy to normalise, prolonged (and widening) monetary divergence vs the Fed/ECB could spur accelerated yen depreciation that causes financial havoc, feeding back into the real economy. For now, however, the hunt for inflation means that the BoJ has little choice but to stay the course for the foreseeable future – even if it does so alone.

By Konstantinos Venetis, Senior Economist, TS Lombard

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