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Whatever It Takes in Japan? It Takes an 'Audacious' Monetary Policy!

March 28th, 2013

by Richard Clarida and Tomoya Masanao

of PIMCO

  • The Bank of Japan (BOJ) will have to make some key monetary policy decisions soon, given new Governor Haruhiko Kuroda’s sincere but ambitious desire to defeat deflation and achieve a 2% inflation rate within two years.
  • The BOJ has lagged far behind other major central banks in the deployment of its balance sheet since the onset of the financial crisis.
  • Expect Japan’s monetary policy to be more aggressive and experimental as it shifts toward reflating the economy. For global investors, this may mean a modest economic growth contribution from Japan, at least over a cyclical horizon, as well as additional central bank liquidity pouring into global markets.

In selecting Haruhiko Kuroda as the new governor of the Bank of Japan (BOJ), Prime Minister Shinzo Abe has made a superb and shrewd choice. Mr. Kuroda is widely respected in global financial circles following his tenure as the Vice Minister of Finance for Intentional Affairs from 1999–2003. He knows like few others the global players, the bond and currency markets, and – perhaps most importantly – the inner workings of the Japanese bureaucracy, where big plans go sometimes to thrive or, all too often, to die. Moreover, in his writings and speeches, Mr. Kuroda has made a consistent and forceful case that the BOJ can and must defeat price and wage deflation if Japan hopes to restore the durable economic growth and balanced prosperity that has been sorely absent in that country for at least a generation.

Given Mr. Kuroda’s sincere but ambitious desire to defeat deflation and achieve a 2% inflation rate within two years, the BOJ will have to make some key monetary policy decisions in the coming months. In the words of Abe advisor Koichi Hamada, the BOJ will need to pursue an “audacious” monetary policy.

Policy decisions facing the Bank of Japan

Policy inertia is no longer a viable option. In the coming weeks and months, the BOJ must make at least four crucial monetary policy decisions as it assembles a new framework to escape the deflation equilibrium and sustainably reflate the Japanese economy:

  • What is the scope of the reflation program?
  • What is the scale of the program?
  • What is the commitment to the program?
  • What is the best way to communicate the program?

The combination of zero growth expectation, zero inflation (or deflation) and the zero lower bound for the policy rate has rendered traditional monetary policy impotent in Japan. The resulting excess in private sector savings has in turn helped finance a domestic fiscal deficit while leaving a current account surplus. That steady surplus has contributed to the Japanese yen’s appreciation. Yen appreciation has also been supported by Japan’s high international investment position as well as its status as a perceived “safe haven” currency in a low global growth world. In turn, this trend appreciation of the yen has reinforced deflation expectations in the economy. The BOJ under Mr. Kuroda needs to commit to aggressive policy to break this deflationary trap.

What is the scale and scope of the program?

Mr. Kuroda inherits the Asset Purchase Program (APP) undertaken by his predecessor, Masaaki Shirakawa, in 2010 and recently extended into an “open-ended” program. Under the original APP, the BOJ has been buying Japanese government bonds (JGBs) and treasury discount bills (see Figure 1) but only out to a self-imposed limit of three-year maturities. The extension of the APP into an open-ended program is slated to commence in January 2014; the BOJ currently estimates it will increase its holdings of JGBs and bills by at least 10 trillion yen under the APP in 2014.

While these amounts expressed in trillions of yen may appear impressive, as Figure 2 shows, the BOJ has lagged far behind other major central banks in the deployment of its balance sheet since the onset of the crisis. We expect Mr. Kuroda to greatly expand the scale of the BOJ’s balance sheet and to extricate the bank from self-imposed limits on the maturities of JGBs it buys under the APP. In fact, at his March 21 press conference, Mr. Kuroda mentioned his intention to “lower the whole yield curve” by purchasing longer-dated assets. The easiest way to do this would be to merge the APP JGB program with the existing rinban JGB purchase program (see Figure 3). It will also want to abandon the self-imposed “bank note” rule, which limits the scale of the rinban program to the outstanding stock of publicly held Japanese currency.

As for the scope of the program, the BOJ already has authority and wide latitude to purchase commercial paper, ETFs, corporate bonds and real estate investment trusts (REITs), but it has not to date made ambitious use of these facilities. Under Mr. Kuroda it should. Moreover, we believe the BOJ should not hesitate to ramp up purchases of these risk assets even though the Ministry of Finance (MOF) has yet to grant indemnification for any losses in principal it might suffer on a hold-to-maturity basis. While such indemnification would be desirable, the BOJ does not have the luxury of time if it wants to achieve Mr. Kuroda’s goals of hitting the 2% inflation target in two years and keeping it there.

What is the commitment to the program, and how will it be communicated?

Mr. Kuroda inherits an institution whose recent statements suggest it’s not committed to success. For example, in the statement released after the January 2013 meeting at which the inflation target was raised from 1% to 2%, the BOJ stated it would pursue the APP and possibly other unconventional policies only “as long as it is appropriate to continue,” without specific reference to the inflation target, whereas in prior statements it had vowed to continue “until the inflation goal is in sight.”

The BOJ should – and we believe will, under Mr. Kuroda – express clearly through word and deed its commitment to a new policy program that will remain in place (and be expanded and modified as necessary) until inflation reaches at least 2% and is projected to remain at or above 2% as the program is eventually wound down. One could argue that a 2% target is too high for an economy in a liquidity trap to achieve, but that is not the point. Simply committing to a projected inflation rate of 2% or above would serve at least to reduce the chance of repeating past mistakes, which the BOJ made in 2000 and 2006, of prematurely exiting from its unconventional monetary easing.

For the same reason, the BOJ should and likely will reassess its tendency to overemphasize the tail risk of asset price bubbles or financial imbalances when setting its monetary policy. The focus on these tail risks is premature and only weakens the effectiveness of monetary easing in fixing Japan’s deflation. The good news is that Mr. Kuroda has already demonstrated his awareness of this issue.

While taking all these steps would represent a substantial and – so long as Mr. Kuroda is governor – likely credible commitment by the BOJ to reflate the Japanese economy, there are additional actions the BOJ could take, but won’t (at least not now) because of pressure from the G-7. For example, the BOJ – with support from the MOF – could take a cue from the Swiss National Bank and announce a floor under the dollar-yen exchange rate (say at 100 yen to the dollar) backed up by unlimited unsterilized intervention until its inflation target is achieved. The BOJ and MOF could also consider, but apparently have also ruled out, conducting open market operations via purchases of foreign bonds.

And what about the yen?

While the G-7 has blessed a Japan reflation program that deploys domestic tools to achieve domestic objectives, these constraints will likely be binding on the BOJ, at least for the time being. While we accept this diplomatic reality, we also recognize it will make the BOJ’s job harder. Crucially, Mr. Kuroda and the Abe government will need to stand firm if, as we expect, deploying domestic tools to achieve domestic inflation objectives results in a somewhat weaker yen. As Mr. Kuroda points out, as recently as 2008 (but before Lehman Brothers), the yen was at 110 to the dollar. It surged to 78 yen to the dollar by 2012 not because of a booming and buoyant Japanese economy but because of an unwinding of risk currency carry trades and a flight-to-safety bid for traditional safe haven currencies (including the Swiss franc). The recovery in the Nikkei has been closely correlated with the sell-off in the yen – and the rise in breakeven inflation – that has anticipated Mr. Abe’s election and Mr. Kuroda’s arrival at the BOJ. As the BOJ embarks on its journey to reflate the Japanese economy, equities, breakeven inflation, and – at least for a while – the yen will likely rise or fall together as the markets gauge the BOJ’s progress in achieving its inflation target. Reflating Japan will take time and skill, and may also require some good luck. Mr. Kuroda possesses the skill. We hope circumstances provide him the time … and the luck.

Investment implications

The BOJ will make an important ideological shift under Mr. Kuroda’s leadership: The central bank will be “targeting inflation,” which would be a U-turn from somehow “tolerating deflation” over the last decade or so. The BOJ’s actions will follow its ideology. Expect its policy to be more aggressive and experimental. For global investors, this may mean a modest economic growth contribution from Japan, at least over a cyclical horizon, as well as additional central bank liquidity from the world’s third-largest economy pouring into global markets. Already investors are anticipating new BOJ monetary easing by using the yen as one of their funding currencies in global portfolios, and we expect this to continue for some time.

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