Investors are now debating what the next step will be for the Bank of Japan. It is a dramatic turn, isn’t it? Earlier this year, the consensus view was that the BOJ would move forward with additional easing – the question was ‘when’, not ‘if’. Six months later, despite Japan’s consumer price index (CPI) falling back to nearly 0% year over year, the consensus seems to have shifted to no additional easing. Some even go one step further, arguing that ‘tapering’ of the quantitative and qualitative easing (QQE) would be the BOJ’s next action. How should we look at it? Here is a framework to consider.

Where are we relative to the BOJ’s 2% inflation target?
Predicting central bank policy starts with looking at the ‘distance’ between policy targets and current states. After years of debating the appropriateness of explicitly defining the inflation target, the BOJ finally entered a new regime of inflation targeting at 2% in January 2013. Two months later, under new Governor Haruhiko Kuroda’s leadership, the BOJ embarked on a large scale QQE program, aiming to achieve the target roughly within two years. Inflation rates, measured here as CPI excluding fresh food (called Japan’s core CPI), responded to the BOJ’s QQE and rose to 3.4% year over year in May 2014 but then fell to 0.1% a year later despite the bank’s surprise additional easing in October 2014. Though much of the large swing in core CPI can be attributed to oil prices and a 3-percentage-point increase of consumption tax (VAT) rates in April 2014, underlying inflation also remains weak.

Based on the seemingly long distance from the current inflation rate to the target level of 2%, one could simply argue that the BOJ should ease more. The forecasted inflation rate also suggests so; the consensus forecast for core CPI is about 1.0% a year from now, which we think is reasonable yet is well below the target. But investors should take into account other factors that we believe are key drivers for Kuroda BOJ’s policy.

What are other drivers for the BOJ?
Investors should take several factors into consideration when attempting to predict the BOJ’s policy: Kuroda’s philosophy and beliefs (or what we think they are), the secular context, the policy target and the policy implementation challenge.

Legal mindset. To understand Kuroda’s monetary policy, consider his academic background, which originates in law. In his 2005 book, “Success and Failure of Fiscal and Monetary Policies” (my translation; it is published only in Japanese), he refers to the criminal law concept of ‘anticipated possibility’ and how his legal mindset would shape his monetary policy as Governor:

... Japan’s deflation happened as a result of several external and internal factors and ... therefore it is not fair to say that (the BOJ’s) monetary policy (mistake) was always the biggest cause of deflation.... However, this does not mean that monetary policy should not be responsible for deflation. Rather, it is monetary policy that should be responsible for it. This is because central banks are mandated to stabilize prices while avoiding deflation and inflation.
In other words, as the BOJ has a legal mandate of price stability defined by the BOJ law, the bank owns responsibility for deflation – as it would have been able to avoid it – whatever the causes. Of course, when anticipated possibility does not exist, noncompliance with the law can be justifiable.

(Translation and emphasis are mine.)

Kuroda uses the 1973 oil shock as an example. He argues that while the first-round effect on inflation of an oil price hike is not a central bank’s responsibility, the second-round effect should be, stating that ‘ ... if a central bank lets the one-time oil price hike morph into medium term inflation, the central bank should be called to account.

Kuroda’s legal mindset seems to serve as a fundamental basis for his bold policy actions to date.

‘Adaptive’ inflation expectations . Kuroda subscribes to a hypothesis that inflation expectations are ‘adaptive’, rather than ‘rational’, meaning that people form future inflation expectations based on past or current actual inflation. From his speech on 19 April 2015:

In a recent study, Mr. Jeffrey Fuhrer, Executive Vice President and Senior Policy Advisor at the Federal Reserve Bank of Boston, using U.S. time series data, finds that past inflation accounts for 40 percent of the variation in four-quarter inflation expectations. Looking at data for Japan, similar reduced form regressions tend to find that past inflation accounts for a significantly larger part of variations in inflation expectations. These contrasting results suggest that inflation expectations may be better anchored – that is, less susceptible to developments in past inflation – in the United States than in Japan.”

This is important. A central bank can look through short-term fluctuations of actual inflation if inflation expectations are rational rather than adaptive and anchored to the central bank’s inflation target. Otherwise, or in Japan’s case where inflation expectations are not anchored and are influenced heavily by actual (declining) inflation, the central bank will likely respond to it. Kuroda’s economic belief of the adaptive nature of inflation expectations in Japan and his legal mindset with the anticipated possibility argument probably explain the BOJ’s surprise decision to ease policy further in October 2014 as a response to falling oil prices. In his view, any second-round effect of falling oil prices to lower inflation expectations should be the BOJ’s responsibility, and the chance of that effect materializing was high given the adaptive nature of inflation expectations in Japan. Going forward, any major shock (for instance, an equity sell-off or currency appreciation) deemed significant enough to depress inflation expectations would likely be a trigger for the BOJ to ease further.

Secular policy mix and an external factor. Ending deflation requires a coordinated monetary and fiscal reflation policy. While Japan does not have the luxury of policy flexibility on the fiscal side, a premature tightening of fiscal policy will likely be avoided under Prime Minister Abe’s leadership. The recent announcement of the government’s policy on fiscal reforms sent a clear message that this government will pursue fiscal reforms by economic growth as opposed to spending cuts or large tax increases. The BOJ will have to play a major role in assisting this government’s growth-led fiscal reforms, and will have to remain easy; it will be subordinate to the fiscal authority – given the clear challenge on the fiscal side in Japan – when economic conditions appear to warrant tightening or a normalization of the reflationary policy stance.

China is in a secular economic slowdown amid deleveraging, which is a powerful external headwind to Japan that requires accommodative policy. While slower growth in China can benefit commodity-importing economies such as Japan and the U.S., it will certainly be negative for global export demand, particularly in Asia. China was already the third-largest importer for the world economy (after the U.S. and Euroland) 10 years ago, and has doubled its imports to US$1.8 trillion per year since then, making it near Euroland’s level.

BOJ policy ‘goalpost’. While the factors discussed so far may suggest further easing is a likely action for the BOJ, a few other factors suggest that it is not a slam dunk.

Two-percent inflation is the BOJ’s stated ‘goalpost’, and the Kuroda BOJ is strongly committed to achieving it, but investors should not rule out the possibility that this goalpost becomes more flexible. A 2% inflation target, as Kuroda said, is an ‘international standard’, and targeting anything lower would be self-defeating as any resulting currency appreciation could be deflationary. Yet is 2% really appropriate in the most demographically challenged economy? Targeting high inflation usually is a hard sell to the elders. In Japan, more than 40% of the household population is 65 years or older. Inflation is an economic drag for those dependent on spending from their savings and, importantly, elders are a very large political constituent in Japan. The administration learned a hard lesson of how inflation – whether a result of a VAT hike or weak currency – can hurt consumers (even workers if they have no meaningful wage growth to offset it) and, hence, weaken political stability.

Moving the goalpost explicitly by lowering the target from 2% to, say 1%, would be highly unlikely, in our view, but doing so implicitly by operating inflation targeting in a more flexible manner is a possibility. The BOJ appears to have already made a first step for the change, as it recently delayed the projected timing of achieving the target from the initial commitment of roughly two years from the start of QQE in April 2013.

QQE technical limits. The BOJ’s QQE is massive, purchasing twice as much in Japanese government bonds (JGBs) as the country’s fiscal deficit, and it cannot continue at this pace forever. The BOJ is already the largest holder of JGBs, with a 27% share of the total amount outstanding. The BOJ would own 65% (!) in 2020 if QQE continues at the current pace. But even before then, the BOJ would likely face difficulty in continuing QQE as, at some stage in the future, banks and insurance companies would stop selling JGBs as their JGB holdings reach the minimum levels required for their collateral or liability-matching purposes. Though we do not believe this is a near-term risk yet, additional QQE would need to bear the future trade-off of bringing forward technical limits of QQE.

Putting it all together …
Kuroda’s commitment to pursuing the BOJ’s price stability mandate remains firm. The secular policy mix and external economic headwinds suggest an accommodative policy stance in the medium to long term. Even in a successful reflation scenario, the BOJ would likely continue financial repression given Japan’s fiscal challenge.

In the near term, however, the status quo with the current QQE will most likely be the case, while additional easing later this year remains a possibility. True, CPI inflation rates are unlikely to rise close to 2% in 2016. However, the BOJ has already shifted to a more flexible approach in its inflation targeting. Also, corporations (particularly large ones) seem to have made a secular turn from a deflationary mindset to a stated intention to invest and compensate more. Given this positive secular momentum in play, the BOJ is in no hurry. Additional easing will become more likely after a deflationary shock (e.g., equity, currency or oil) with imminent risks to inflation expectations.

Investment implications
What does this all mean for investment? The Japanese yen is still in a secular bearish trend, but at least in the near term, the pace of its depreciation will likely be slow from the current valuation. That said, Japanese risk assets will continue to be supported. The long end of JGB yield curve remains attractive on a relative basis, given the BOJ’s powerful support firmly in place, particularly versus the rest of the curve and even versus comparable debt of other developed countries. One should, however, remain mindful of the eventual (if not imminent) technical limit of the BOJ’s current policy.

Tomoya Masanao
Managing Director

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Tomoya Masanao

Head of Portfolio Management, Japan

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