Battle with deflation far from over for new-look Bank of Japan

Omens look good as central bank leaves years of timid and ineffective policy behind


It has been a breathtaking start to the year for equity investors, with the upward move in stock prices that began during the final quarter of 2012 continuing apace. Indeed, the double-digit percentage point gain in US stock prices pushed the major market averages to record nominal highs.

However, the market action in New York pales in comparison to Tokyo, where Japanese stock prices have jumped by more than 30 per cent since the final trading day of 2012, and almost 60 per cent over the past six months. The rise stems primarily from major developments in the monetary policy arena, following the return of the leader of the Liberal Democratic Party (LDP), Shinzo Abe, as prime minister late last year.

The LDP was swept to power on promises that it would urge the Bank of Japan (BOJ) engage in a far more determined fight to overcome Japan’s entrenched deflation. Abe threatened to amend the 1998 Bank of Japan Act if the central bank did not adopt a 2 per cent inflation target at the annual review of its “price stability goal in the medium-to-long term” early in the new year.

Abe’s criticism of the monetary authority appears reasonable, given that its “powerful monetary easing” via the adoption of a zero-interest-rate policy in the spring of 1999, alongside its five-year experiment with quantitative easing (QE) from 2001 to 2006, consistently failed to lift the Japanese economy out of its deflationary malaise.

The record confirms that the BOJ’s unconventional monetary policies, time and again, fell short of that required to end deflation. First, the maximum increase in its balance sheet during the 2001 to 2006 period was little more than 40 per cent – roughly half the percentage point increase achieved by the US Federal Reserve in the weeks that followed the collapse of Lehman Brothers in the autumn of 2008.

Second, the composition of assets purchased was not aggressive enough to prompt a potent portfolio rebalancing effect. Indeed, the assets supplied were typically not sufficiently different than the assets purchased – in terms of both duration and risk – and, as a result, investors had little incentive to rebalance their portfolios towards longer-duration and higher-risk securities. The QE experiment had a minimal impact on asset prices; stock prices did not benefit at all, while any reduction in the spreads on corporate debt was confined to those firms with the highest ratings.

Finally, the BOJ consistently undermined its efforts through its own inappropriate communications. Indeed, the central bank consistently argued that persistent deflation had nothing to do with shortcomings in its unconventional monetary policies, but stemmed instead from structural issues that had lowered the economy’s potential growth rate. The monetary policymaker’s statements clearly signalled that the central bank believed it did not have the tools to defeat deflation alone, which almost certainly reduced the potency of its efforts.

Sceptics would be right to question whether Abe’s pre-election rhetoric will be followed by a meaningful change in monetary policy. The omens so far look good, as the BOJ adopted the 2 per cent ”price stability target” at its two-day policy meeting in late-January, and this was followed by the appointment of Haruhiko Kuroda, a long-time critic of the BOJ, as governor of the central bank in March.

Further, at Kuroda’s first meeting as governor, the central bank announced a radical overhaul of its monetary policy framework, involving the introduction of new “quantitative and qualitative easing” that is designed to achieve the inflation target of two per cent within a two years.

The new measures, which include a doubling of the monetary base by the end of 2014 and an extension of the average duration of bond purchases from three to seven years, are a clear departure from the timid policies of the past, and demonstrate a firm commitment by the BOJ to bring deflation to an end.

Survey evidence before the BOJ’s bold policy announcement suggests that recent developments have already had a meaningful impact on inflation expectations. Indeed, households’ inflation expectations jumped to a four-and-a-half year high in the most recent survey, while the percentage of households expecting their earnings to fall a year from now dropped from 45 to 37 per cent.

Although the omens are good, the battle with deflation is far from over. The shift in the BOJ’s policy stance has already been reflected in the value of yen, which has registered a sizeable double-digit percentage point decline against the world’s major currencies. Although this is undoubtedly good news for the export sector, the rise in import prices – particularly energy – could constrain household spending and add to deflationary pressures.

Further, should the BOJ push real interest rates deep into negative territory, the result could be an exodus from the government bond market and the upward move in yields might not be easily contained. The increase in funding costs could unhinge public finances, while the decline in asset values could precipitate a banking crisis. Both events would be deflationary.

Recent actions demonstrate the BOJ’s determination to end years of deflation; investors will be aware, however, that the battle is far from won.