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Summary: While deflation has been a problem for Japan for a long time, the country’s efforts to generate inflation have been a clear policy divergence this year, when global central banks are intensifying their fight against price pressures.
While deflation has been a problem for Japan for a long time, the country’s efforts to generate inflation have been a clear policy divergence this year, when global central banks are intensifying their fight against price pressures.
The Bank of Japan’s (BOJ) yield curve control (YCC) policy attempts to keep the 10-year Japanese government bond (JGB) yields below the 0.25 percent threshold. While this is needed to bring inflation back, it has proven catastrophic for the Japanese yen which has moved to 24-year lows against the US dollar recently. The weakening yen is driving up prices, hurting consumers and businesses and posing a political headache for a government that will be facing elections in July. Remaining committed to the YCC will mean even higher inflation, which can be explosive for an economy with the highest debt load in the developed world.
The market is also testing the BOJ’s commitment to the YCC by driving JGB yields above the central bank’s tolerance limit, including in the longer tenure and the futures markets, and forcing the BOJ to accelerate its bond buying. As the Fed continues to hike rates and global yields surge, the BOJ will need to ease more and buy more JGBs, thereby further expanding its balance sheet.
How long will the ‘transitory’ inflation rhetoric last?
We saw the Fed pivot in November as it switched from a ‘transitory’ inflation rhetoric towards accepting that inflation will be higher for longer and started sending signals of a tighter monetary policy. The BOJ is under similar pressure to capitulate now. Core inflation in April was above the BOJ’s 2 percent target for the first time in over seven years, but this is mostly supply driven as commodity prices have rallied. Governor Haruhiko Kuroda has reiterated that current cost-push inflation without major wage hikes will prove short-lived, suggesting that he will remain committed to an easy policy unless wage pressures build.
However, an upward revision in the Labor Ministry’s wage data for March to 2 percent (from a preliminary print of 1.2 percent) signalled that pay increases are keeping pace with inflation. But April cash earnings decelerated to 1.7 percent, with real earnings still down at -1.2 percent. Moreover, wage data can be volatile and, with a weaker yen squeezing corporate profits, the scope for sustained increases in wages remains weak.
Still, consumers are feeling the pinch from higher inflation as household budgets are dented, which will stall the recovery in consumer spending in Q3. A yen weakening towards 150 against the dollar will push up prices even further, which is particularly bad news for millions of retirees living on fixed incomes. The public angst on inflation was also obvious after the backlash on Kuroda’s comments noting that ‘Japanese households' tolerance of price rises has been increasing.’ A key factor to watch, therefore, would be the inflation expectations which are likely to shape the BOJ’s policy plans if the commitment to the YCC begins to weaken at all. Japanese households see inflation at 6.4 percent next year on average, the highest reading since 2008, according to a BOJ survey. If this continues to rise, it could test the tolerance of Japanese households and therefore of the BOJ’s easy policy in the wake of global tightening.
Is currency intervention an option?
With the BOJ being the only major central bank that is still easing, the pressure on the currency is obvious. Not just that, the BOJ has been the most aggressive central bank in terms of bond market interventions and has destroyed the ‘free market’ mechanism for decades. Authorities continue to claim that a weaker yen is good for the economy, which it has been traditionally, and most BOJ interventions have been on the stronger side of the yen with a bias to weaken it. This was true until the big automakers concentrated their production bases in Japan and exported cars to the rest of the world. But manufacturing is more spread out globally now, and the same kind of currency benefits do not occur when the yen weakens. Moreover, with business costs rising due to energy costs and supply chain issues, any likely benefit from a weaker yen has been eroded.
Furthermore, the pace of the yen’s slide has sparked concerns. The USDJPY rose from 115 at the end of February to a 24-year high of 135 in just over three months-a fall for the JPY of over 17 percent. The next key levels to watch are the 1998 high of 147.66 and the 38.2 percent Fibonacci retracement level from the 1982 peak of 277.45, which is at 152.63. Moreover, the yen’s weakness is not uniquely against the USD. Bloomberg’s Correlation-Weighted Currency Index for the yen, a gauge of its relative strength against a broad basket of G10 peers, has also slumped to a seven-year low. The chart below also shows the yen’s weakness on a real effective exchange rate (REER) basis compared to the yuan, despite China’s central bank also maintaining an easing bias.
Japanese authorities have tried several rounds of verbal intervention—some of which had an effect—and the yen recovered. However, the impact has started to weaken more recently as the forces of rising yields continue to get stronger. After a three-party meeting between Japan’s Ministry of Finance, the BOJ and Financial Services Agency, authorities sent out a written warning to express ‘extreme concern’ about the rapid decline of the yen against the USD, to little avail. Most recently, the June BOJ meeting included a vague statement that the Bank needs to pay attention to the FX level, but failed to give any specific levels in order to avoid speculation.
Hopes of a coordinated intervention response along with other G7 countries have been thrashed, given concerns around the US and global inflation levels. Even if it were to occur, the impact of a currency intervention would likely be short-lived. It also would not change the fundamental framework that yield differentials will continue to rise if the BOJ sticks to its YCC policy, as global yields continue to move higher. Currency intervention in this environment is also not credible given it is the BOJ’s policy itself that is the cause of yen weakness.
The beginning of the end of the YCC . . .
The question of whether Kuroda will abandon the YCC is likely to linger for at least another quarter, and might intensify if we get closer to another 75 basis points (bps) rate hike from the Fed in July. However, the pressure may ease if global yields top out amid rising concerns of a recession.
Being so used to quantitative easing over the decades, there were no signs that the Fed or the European Central Bank (ECB) will change course, and abruptly at that. It isn’t hard to expect the BOJ to take the tough road as well one day, a change that will most likely be sudden. A lot is at stake beyond the domestic and global financial ramifications of reversing such a policy, but most importantly, Kuroda is close to the end of his term (which ends in April 2023). He would want to be remembered as the one who brought (wage) inflation back to Japan, instead of the one who adopted and then abandoned the YCC for its failure.
There are other choices that he may prefer to take, such as maintaining the course despite the mounting pressure or tinkering with the policy by shifting the YCC cap levels by a smaller or slightly larger amount. These remain the most likely outcomes for now and still hold the potential for a massive yen recovery, given the overstretched positioning. Similar policy tweaks did happen in 2018 in the later phase of the 2015–2018 Fed tightening cycle. Back then, the BOJ widened the 10-year yield target band to ±0.2 percent from ±0.1 percent in response to the market-driven yield increases due to higher global rates. This was further widened to ±0.25 percent in 2021. Although such policy tweaks would still leave the BOJ miles away from hiking its benchmark lending rate, which is stuck at -0.1 percent, they would nevertheless be a significant step towards normalisation.
. . . and what it could mean for the global financial markets
Japan has accumulated an enormous amount of foreign assets over the decades. A host of retail and institutional investors are exposed to the yen carry trade by borrowing in yen but investing in foreign markets in search of extra yield and liquidity. Therefore, if the ‘runaway train’ forces the BOJ’s Governor Kuroda to back down on his commitment to YCC, it can possibly risk an ugly systemic collapse of the global financial system as contagion risks are significant.
Domestically, a shocking policy move which makes the entire yield curve shift upward could lead to a loss in trillions of yen for the BOJ's holdings of JGBs on its balance sheet. The selloff in JGBs will likely have a cascading effect through the global economy which will lose a key anchor. This in turn could spark an upward pressure on borrowing costs globally. As yen carry trades reverse, liquidity could flow back into Japan, and that would be a drain on global liquidity conditions. Japanese stocks will likely get hammered as businesses get hurt due to higher borrowing rates and a stronger yen (compared to their current assumptions), and global equities may likely join the selloff. This would mean that Japan’s economy may be crushed before it fully recovers from the pandemic. There would be a spike in yen volatility, with effects reverberating across the global FX markets as well.
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