Is Japan’s Sun as Bright as it Appears?

What is happening in Japan? Japan’s economy does not receive as much international attention as it once did; the combination of China’s rise and two decades of relatively weak growth in Japan has seen to that. Yet it is the world’s third largest economy, and it has been at the forefront of spearheading unconventional monetary policy.

Often a question is posed as to whether other economies might follow in Japan’s footsteps. They already have in terms of very low interest rates. But in recent years the Bank of Japan (BOJ) has been buying domestic bonds and equities at a rapid pace, thus underpinning financial markets in Japan. This shows no sign of stopping.

Stronger growth, but weakly underpinned

Last week, financial markets were surprised by news that Japan’s economy had grown by a stronger than expected annualised rate of 2.1% in the first three months of this year. However, upon examination, the breakdown of the data suggested the economy might be weaker than the headline figure. Consumption, investment and exports were weak, and it was only because of sluggish imports that the GDP figures were stronger than the previous quarter, when they rose 1.6%.

Indeed, in March BOJ Governor Kuroda had talked of the domestic economy being “solid”, helped by “robust” capital spending. Since then, however, the BOJ’s position has shifted significantly, largely because of external factors, namely the trade dispute, and the fear that this is now impacting Japan.

The release of the Tankan – the BOJ’s quarterly survey of Japanese businesses – in early April showed capital spending plans weakening and pointed to an easing in business sentiment. Business conditions, as shown by the Diffusion Index (DI) for large firms fell from 21 in the previous Tankan to 17, for medium-sized firms from 17 to 13 and for small firms from 12 to 10.

Potentially no limit to monetary easing

Japan is terrified at the prospect of deflation. Its fear is that if the economy weakened then this will return. As a result, and ahead of last week’s GDP figures, the BOJ had signalled a change in thinking. It is not just that the Bank is prepared to ease again, if needed, but its feeling is that there is no limit to possible monetary easing.

The annual rate of nationwide inflation was 0.5% in March. The BOJ’s projections for inflation are 1.1% in fiscal year 2019, followed by 1.4% in 2020 and 1.6% in 2021. These would be too high if the economy slowed.

Also, if the economy softens, not only will the BOJ ease further, but also the government’s planned increase in the consumption tax rate from 8% to 10%, planned for October, might be delayed. Despite all this, the yen continues to be seen as a safe haven, given uncertainty elsewhere.

The power of unconventional monetary policy

The BOJ’s monetary policy is unconventional. They refer to it as “powerful monetary policy” based on yield curve control aimed at achieving 2% inflation. It is called "Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control”, with the following main components: (a) Short-term policy interest rate at -0.1%; (b) A target level of 10-year Japanese Government Bond (JGB) yields at around 0%; (c) Buying of JGBs to control the yield curve.

In April the BOJ announced, "The Bank intends to maintain the current extremely low levels of short- and long-term interest rates for an extended period of time, at least through around spring 2020, taking into account uncertainties regarding economic activity and prices including developments in overseas economies and the effects of the scheduled consumption tax hike."

Policy thus remains very data dependent. As Governor Kuroda said in a recent speech, “The Bank considers that there is a fair possibility that the current low interest rates will be maintained beyond (spring 2020) depending on future developments.”

An important indicator the BOJ follows is their measure of the output gap, which reflects spare capacity in the economy and demand relative to supply potential. This graph would worry the BOJ if is sustained.

Japan’s output gap

Source: Bank of Japan

The BOJ’s policies are very supportive of domestic financial assets in Japan. Financial markets have been a major beneficiary of the shift in policy. The BOJ has been an active buyer – almost as if it were the buyer of last resort – of Japanese Government Bonds and equities. There is no sign of this halting.

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