Article / 26 August 2016 at 0:34 GMT

Inflation update keeps pressure mounting on BoJ

Managing Director / Technical Research Limited
New Zealand
  • Traders are immune to Japanese CPI declines - USDJPY was hardly affected
  • We will have to wait till September 21 for an assessment of Japan's QQE
  • The Bank of Japan has announced a doubling of its USD lending program

By Max McKegg

Today’s inflation update from Japan was gloomy news for the Bank of Japan. It’s benchmark, the Consumer Price Index (less fresh food) declined 0.5% over the year to July.

This was slightly worse than economists had expected, but USDJPY hardly moved - traders are becoming immune to bad news out of Japan.

But expectations are growing that the Bank of Japan will have to “do something” when it meets next on September 20-21, the same day as the US Federal Reserve.


Source: Bank of Japan

In a speech earlier this month Bank of Japan deputy governor Kikuo Iwata blamed the recent deceleration in the rate of increase in the CPI on “the yen’s appreciation and the delay in the timing of inflation expectations”.


Bank of Japan governor Haruhiko Kuroda says there is "sufficient chance" of
central bank action on September 21 - but what exactly does he mean? Photo: iStock

Previously the blame had been put on declining energy costs. So does this mean the exchange rate is now “in play” as a policy target ? Perhaps.

But we will probably have to wait until the Bank’s next meeting on September 20-21 when a “comprehensive assessment” of the QQE with a negative interest rate policy will be presented by the staff and discussed by the BoJ board.

This chart shows why the appreciation of the yen is starting to register with the policy makers: it’s rising across the board.

xxx Source: Reserve Bank of Australia

As for the other reason given for deceleration of the inflation rate – the delay in the timing of inflation expectations – the BoJ thinks this is due to an “adaptive formation mechanism”, a technical term for a situation where formation of inflation expectations tends to be strongly affected by the observed CPI.

In other words, today’s inflation rate becomes tomorrow’s expectation, especially after a prolonged period of deflation. The BoJ contrasts this with the case of the US where surveys show expectations are anchored around the target set by the Fed.

So for the BoJ, its essential the CPI starts moving back into positive territory as soon as possible. But how is it to do that ?

There is a growing expectation that we will see some more easing by the BoJ at its next meeting on September 21, not necessarily because events have taken a turn for the worse but because the current policy is not working. Hence the review ordered by the Board. This is how the deputy governor Iwata put it:

"The price stability target of 2 per cent has not been achieved yet, despite unprecedentedly large scale monetary easing. With this in mind, we would like to re-examine the transmission mechanism of policy effects and possible factors that may have hampered this mechanism....At the same time it has had a variety of of impacts on financial institutions and markets. We would like to assess the mechanism of this policy as well."

However, its seems the inflation target itself is not up for discussion, merely the way to go about achieving it. The “transmission mechanism” has been a a flattening of the yield curve.

With rates now negative out to fifteen years, it’s hard to see how the policy has been "hampered” – unless the BoJ was hoping for an even lower curve.

Ahead of the policy review, the company line is that year-on-year rate of change in the CPI will reach “around 2 percent during fiscal 2017”.

USD shortage creating distortions

At its last meeting, the Bank of Japan also announced a doubling of its USD lending program. This was in response to a tightening of USD liquidity in money markets which has seen cross currency basis spreads hit negative extremes in funding currencies such as JPY.

This was making it difficult for Japanese institutions to invest in US bonds on a hedged basis. On the other hand it provides an opportunity for those who do have access to plenty of dollars, for example US-based pension funds and central banks like the Peoples Bank of China.

They can invest US dollars via a cross currency swap at the 3-month Libor rate of 0.80% and borrow JPY at close to zero. On top of that they will receive the basis, set by supply and demand, which has stretched out to 0.65%.

The borrowed JPY can then be invested in a Japanese Treasury bill, even at negative 0.20%, and still the return is 1.25% on a gilt-edged security. (Rate differential of 80 basis points plus basis of 65 basis points less bill yield of 20 basis points).

That’s a lot better than the 0.30% on offer from a US Treasury bill that less imaginative types are settling for.
Source: Bloomberg

The opposite situation applies to a Japanese-based investors looking to invest in US securities with the currency exposure hedged. That window of opportunity is closing. See here 
BoJ governor Haruhiko Kuroda said in a newspaper interview last weekend that there was “sufficient chance” the bank would take some action at its September meeting.

Whatever that means is unclear and probably got lost in translation. Regardless, today’s inflation update suggests something’s gotta give: either the “comprehensive assessment” of monetary policy at the meeting will see the 2% target abandoned or more imaginative measures will be introduced.

That won’t include helicopter money because it would require legislative change. We will have to see what other rabbits Mr Kuroda can pull out of his hat.

-- Edited by Adam Courtenay

Max McKegg is managing director of Technical Research Limited. If you would like Max’s specific trading advice on USDJPY then you are welcome to contact him here 


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