Bank of Japan holds its nerve and punts on Abe
- Traders had not realised the implications for Shinzo Abe's monetary policy
- Attainment of 2% inflation has been edged out again to "end of fiscal 2017”
- Japan's capacity utilisation is lagging in line with subdued consumer spending
By Max McKegg
The Bank of Japan maintained a steady-as-she-goes course at its monetary policy review meeting last week, with only a slight trimming of the sails to allow for “uncertainties surrounding overseas economies”.
More ETFs will be purchased, but there was no change to the deposit rate nor the government bond buying program.
FX traders had been expecting a bolder move, and expressed their disapproval by pushing USDJPY down to 102 by the close of Friday trading in New York, while bond dealers drove the yield on Japan’s ten year government bond up from –0.28% to –0.18%, a big move.
The post-meeting statement threw the markets a bone with promise of a “comprehensive assessment” of QE effectiveness at the Bank’s next meeting on Sept 20-21.
In retrospect, it seems traders had not realised the implications for monetary policy of Prime Minister Shinzo Abe’s “large-scale stimulus package”, preliminary details of which were announced a week ago.
Bank of Japan Board members did, and built a substantial fiscal boost into their updated economic forecasts, in turn allowing them to hold the line on inflation forecasts for 2017 and 2018. No change to the forecasts meant no change in monetary policy.
Nevertheless, attainment of the 2% inflation goal has been edged out again from “during fiscal 2017” to “toward the end of fiscal 2017”.
This year is a write off. A couple of hours before Friday’s meeting wound up, the June inflation update showed the BOJ’s benchmark, national core CPI, had declined at a year-on-year rate of 0.5%, while core-core CPI (which excludes energy prices) was rising at a measly 0.4%.
The only glimmer of hope was that the flash estimate for July (via Tokyo prices) showed a slight improvement.
According to the BoJ, under par inflation in fiscal 2016 is due to “the recent appreciation of the yen and a decline in inflation expectations suggested by sluggishness in base pay rises”.
So what of this “large scale stimulus package” that the BoJ is hoping will get them off the hook? We’ll get more detail this week, but initial guidance suggests a boost in government spending equivalent to 3-4% of GDP.
The table below shows this would be nothing exceptional: the post-GFC package was 5.5% of GDP. It would seem some surprise to the upside will be required to convince the markets the fiscal stimulus is large enough to offset BoJ timidity.
Source: Bank of America Merrill Lynch
The probability of significant increase in government spending is the main reasons the BoJ made no changes to its inflation forecasts for fiscal 2017 (1.7%) and 2018 (1.9%).
Another is its continued faith in a closing of the output gap – the extent to which labor and capital resources are being put to work.
The unemployment rate is 3.1%, so no problems there, but capacity utilisation is lagging in line with subdued consumer spending. Nevertheless, the output gap is estimated to be close to zero, suggesting more government spending could push it into positive territory and therefore, according to economic theory, spark inflation.
With the labor force growing at a snail's pace, Japan’s potential growth rate is only 0.5% per annum. Anything above that on a consistent basis should, again in theory, produce a “virtuous cycle” of wage increases, consumer spending, business investment, inflation.
Recharging the virtuous cycle is needed to defeat Japan’s still deeply imbedded “deflationary mindset”. According to the BoJ, forward inflation expectations are determined by today’s inflation rate: consumers and business project forward what they are experiencing today.
With the CPI expected to remain low “for some time” due the effects of the past decline in energy prices, the bank has a job ahead of it to raise inflation expectations.
The drag on the annual CPI from energy prices is forecast to fizzle out early in 2017, but this assumes the oil price will be trending up towards $50/barrel.
The bank’s forecasts rarely mention the exchange rate as a factor in driving inflation, and therefore inflation expectations, but the July Outlook for Economic Activity and Prices, released last Friday at same time as the monetary policy statement, commented that “the impact of foreign exchange rates on consumer prices through import prices is likely to restrain upward pressure on prices, due in part to the recent appreciation of the yen”.
Given the slow progress being made on closing the output gap and spurring inflation expectations, the BoJ must be looking longingly at USDJPY around 102 and hoping the Ministry of Finance will let them off the leash to have a go at triggering a rally.
It’s been some time since the bank intervened, as shown in this chart (click to enlarge), but nowadays, global political pressure allows them to do so only if there is a “disorderly market”, something like a three to four big figure move in USDJPY over a couple of days.
Summarising the risks around their inflation forecasts the BOJ says “risks are skewed to the downside as there is considerable uncertainty over both the outlook for overseas economies and developments in medium-long term inflation expectations”.
They intend to continue with QE with a negative interest rate for “as long as is necessary” to achieve 2% inflation in a stable manner.
The deflationary mindset won’t be overcome until inflation expectations rise; expectations won’t rise until the current inflation rate turns positive; inflation won’t turn positive until last year’s oil price declines drop out the annual calculation, perhaps early next year.
In the meantime the BoJ is stuck in non-man’s-land, punting that Prime Minister Abe’s fiscal package will save the day. The ball’s in his court now.
-- Edited by Adam Courtenay
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.