On some metrics, the Japanese economy does not stand out much from other industrialised economies. Sure, real (inflation-adjusted) GDP growth has averaged only 0.8% year-on-year (YoY) since 2000, but this is not that much lower than that of the eurozone (1.1%). If allowance is made for its demographics (a shrinking population), Japan has done better in terms of GDP growth per capita than the eurozone in the past 14 years. However, due to persistent deflation, nominal (value) growth has been absent for decades. What has been Japan’s monetary policy reaction and what can we expect?
In the fourth quarter of 2015, nominal GDP in Japan matched that of the third quarter of 1994. Moreover, these developments have come against the background of the biggest monetary experiment in modern history. Expansionary monetary policy was one of the pillars of ‘Abenomics’, the three-pillar programme introduced by the Abe government in 2013. It has also been the most successful one in terms of implementation.
Several rounds of quantitative easing have swollen the balance sheet of the Bank of Japan to 76.6% of GDP. After the US Federal Reaserve had fully tapered its asset purchases in early 2015, the Fed’s balance sheet had fallen to roughly 25% of GDP and has been stable since. The balance sheet of the ECB is currently growing, but at 26.4% of GDP, it is nowhere near the size of that of the Bank of Japan.
Another striking feature of the Japanese situation is the outsized government debt pile. Gross debt stands at an impressive 238% of GDP, way higher than that of eurozone countries which are seen as vulnerable on this aspect such as Greece (180% of GDP) or Italy (156%). Taking the large amount of government assets into account, Japan’s net debt ratio is still higher than that of any other OECD country except Greece.
Japan’s monetary policy: is it working?
Massive quantitative easing and high fiscal deficits have not been able to create sustainable inflation. Unemployment is relatively low, but the spring wage negotiations this year look to generate even more modest wage gains than last year’s. Headline inflation was exactly zero in March. Core inflation had accelerated to 0.9% last September, but has moved sideways ever since.
A weaker currency may not have been mentioned as a prime target of monetary policy, but it has been one of the transmission mechanisms though which the BoJ created inflation. When it announced on 4 April 2013 that it would buy JPY 60–70 trillion of Japanese government bonds a year, the yen had already weakened to 96 JPY per USD from below 80 in October 2012. The yen fell further, to above 100 in most of 2014.
But when growth and inflation continued to disappoint, markets started to anticipate a faster pace of asset purchases in late 2014, sending the yen lower. After the BoJ stepped up quantitative easing to JPY 80 trillion a year, the yen weakened eventually to 125 in June 2015. But even this 60% depreciation has not sustainably created inflation. With nominal wages growing slower than inflation (also due to a rise in consumption taxes), households’ purchasing power has actually fallen.
Exhibit 1: benchmark 10-year government bond yields in Japan have been undershooting US and German yields for almost a year
Source: Datastream, BNPP IP, as at 6 April 2016
More recently, the efficacy of monetary policy has met with scepticism. In the market turmoil earlier this year, the yen acted as the traditional safe haven for Japanese and Asian investors and appreciated. The BoJ announced negative interest rates in late January, after having dismissed this option just a week earlier. The yen initially weakened, but in what was seen as a somewhat desperate move, this was short-lived. When the ECB hinted at more easing and followed up in March and when the Fed also started to sound more dovish, the yen rose rapidly to 108 JPY per USD (see exhibit 2 below).
Exhibit 2: the yen’s haven status has given it a boost despite all the quantitative easing (US dollar to Japanese yen exchange rate)
Japan’s monetary policy: what’s next?
So the question is if and how the BoJ may respond. Of course, one can question the effictiveness of monetary policy, but I think it is unlikely that the BoJ is ready to throw in the towel. The BoJ could cut rates further into negative territory. It has introduced a tiered system of interest rates that the BoJ applies to bank reserves, ranging from zero to -0.1%, so the negative impact of negative rates on banks’ profitability is limited. The BoJ will also adjust (raise) the thresholds of the tiered system as banks’ excess reserves held at the BoJ increase with the BoJ’s quantitative easing programme.
But after the January rate cut and the market reactions, the BoJ may be reluctant to go further down the negative rate path. A further expansion of its asset purchases is certainly possible. With the economy possibly back in recession, the BoJ may need to cut its inflation and growth outlook once again. Thus, the recent appreciation of the yen could push the BoJ into action at its next policy meeting at the end of April. In local currency terms, the performance of Japanese equities is highly correlated to the yen, so if the BoJ manages to reverse the yen’s gains, the underperformance of Japanese equities could come to a halt.
Exhibit 3: Japanese equities feel the heat of the yen’s gains (market index performance in local currencies, 1 January 2016 = 100)
Source: Datastream, BNPP IP, as at 6 April 2016
A technical recession in Japan?
Japanese GDP shrank in the final quarter of 2015 and may have done so again in the first quarter of this year. If so, Japan would be in its fifth technical recession (defined as at least two consecutive quarters of negative growth) since the start of this millennium. Weakness has shown up in the manufacturing sector (PMI, orders, production), among households (spending, confidence) and in trade. Export volumes have basically moved sideways for two years. With potential growth as low as in Japan, technical recessions will happen more frequently, as a mid-cycle slowdown can more easily morph in to a recession. However, at this juncture another technical recession would be a blow to the credibility of ‘Abenomics’ and to the credibility of the Bank of Japan. Another round of stimulus could come as early as at this month’s monetary policy meeting of the BoJ, scheduled for 28 April 2016. Policymakers may also opt to wait a while, as core inflation has been stable just below 1% for 7 months now. Even if they do move, it is unclear whether they would choose to cut interest rates further into negative territory or for more quantitative easing. Markets may react sceptically as they perceive that the Bank of Japan is close to the limits of what it can conceivably do.
This article was written in Amsterdam on 13 April 2016 and updated on 20 April 2016.