Bank of Japan board member says 2% inflation target is unfeasible
- USDJPY is closely matching moves in US 10-Year bond
- Inflation updates will be released in the US and Japan this week
- BoJ board member Takahide Kiuichi takes issue with the 2% inflation target
- Kiuchi believes price conditions will remain consistent with Japan's growth potential
USDJPY and the yield on the 10-year US Treasury bond slipped in tandem on Friday, maintaining a link that has been apparent for some time, as shown in the chart below. It’s actually the spread between US and Japanese rates that matters, but with the Bank of Japan maintaining yield curve control the US bond is making the running on its own.
Last week Japan’s monetary policy came under attack from a renegade member of the Bank of Japan’s policy board. His point is that the global consensus of 2% inflation is not appropriate in Japan, and such a one-size-fits-all approach could have dangerous consequences for financial markets and economic activity.
10 year yield chart versus USDJPY (please click to enlarge)
Source: Thomson Reuters
We will analyse that view below, but first a quick look at more immediate matters that may impact USDJPY.
This week we will get inflation updates from the US (due out on Wednesday) and Japan (on Friday). While champagne corks won’t be popped, there will quiet satisfaction at the Federal Open Market Committee when the headline personal consumption expenditures price index (PCE) – the Committee’s inflation benchmark – comes in very close to 2%. Money market traders will, no doubt, respond by increasing the probability of a March 15 rate hike and, equally predictable, FOMC chair Janet Yellen will disabuse them of that notion in a speech scheduled for Friday in which she will emphasise her “first, do no harm’' approach to monetary policy.
The mood will be more subdued at the Bank of Japan when the year-on-year headline inflation number comes in under zero, albeit a slight improvement on the negative 0.5% reached a couple of months ago. Core inflation, which excludes energy price movements, will show little progress.
Apart from the economic data, there will be interest in President Trump’s State of the Union address to Congress on Tuesday. He continues to tantalise traders with talk of “phenomenal” economic announcements, tweeting over the weekend “Great optimism for future of US business, and jobs, with the Dow Jones having an 11th straight record close. Big tax & regulation cuts coming!”
The markets have been giving Trump the populist benefit of the doubt. It’s now time for Trump the pragmatist to start delivering.
Pushing on a string
While we await these developments it is worthwhile to consider some comments made last week by the BoJ board member Takahide Kiuichi, for some time a thorn in the side of his boss, Governor Haruhiko Kuroda. Kiuchi argues that the bank’s 2% inflation target is “unfeasible”, because – largely due to demographic trends – Japan’s potential growth rate is only about 0.5% and there is no “driving force”, certainly not monetary policy, that will raise it sustainably above that level. “Therefore, in my view” he says “price conditions will remain consistent with the economy’s growth potential”.
In other words, forget about 2% inflation unless the potential growth rate can be increased, via a combination of productivity gains and an increase in the workforce (such as by encouraging more women and the elderly to participate). In the meantime, policymakers should accept the reality of 0.5% inflation over the medium term and conduct monetary policy accordingly.
Contrast this with the US where the estimated potential growth rate of 2% matches the Fed’s inflation target.
Based on his assessment of Japan’s economy, Kiuchi thinks pushing forward with the current pace of bond purchases could have a “serious impact on financial markets and economic activity”. He adheres to the view that it is the stock of bond holdings that matters, not the flow. As shown in the chart below, the Bank of Japan already owns close to half of the government bonds on issue, sufficient for it to “secure the accumulated monetary easing effects” by just sitting on its position, buying only to replace maturities. This is essentially what the Federal Reserve has done for the last three years.
In Kuichi’s view, continuing to expand the balance sheet is pushing on a string because monetary policy can have little impact on the structural forces that determine economic growth.
BOJ bond holdings chart
Source: Bank of Japan
In contrast, the majority of his colleagues on the board of the Bank of Japan continue to predict 2% inflation “around fiscal 2018”. Against a background of a 3% unemployment rate and corporate profits at high levels, they “strongly expect” both labour and management will negotiate substantial increases in the upcoming spring wage negotiations and so set in motion the long-promised “virtuous cycle” of higher wages feeding through into higher prices and, in turn, higher inflation expectations.
Meanwhile, Japanese investors have to act in the real world, not the theoretical. The smarter among them have been taking advantage of the blowout in the USDJPY cross currency basis over the last year, caused in large part by one-sided demand from banks and insurance companies looking to hedge currency exposure from investment in the US bond market. The basis has closed up a bit recently as investors hold back while US yields have been rising. Nevertheless, a fully hedged 0.90% in a 10-year US treasury bond still stacks up well in comparison with the domestic equivalent at 0.09%.
US bond hedged chart
Source: Bloomberg. Create your own charts with SaxoTrader; click here to learn more.
The argument for one-size-fits-all inflation targeting is flawed. Japan is a case in point. The inflation target should match the potential growth rate and in Japan that means 0.50%.
Nevertheless, the Bank of Japan is determined to push its balance sheet expansion into unknown territory chasing the elusive 2%, so far without any adverse consequences. However one member of the BoJ policy making board clearly has his doubts, and concerns.
– Edited by Robert Ryan
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Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.