The BoJ: Over-inflated expectations?

Tomorrow brings monetary policy announcements from several major central banks. And in marked contrast to those at the ECB and BoE, which look set to deliver nothing new, the Bank of Japan’s meeting will be momentous, revealing whether new Governor Kuroda has been able to match his recent rhetoric with the substantive action expected of him. And those expectations are high indeed. Japan’s equity markets are close to multi-year highs, JGB yields are near multi-year lows, while financial market expectations of Japanese inflation recently rose (albeit fleetingly) above their German equivalents. Even household inflation expectations have risen. So, will Kuroda be able to convince his fellow Policy Board members to deliver?

Shinzo Abe’s new government has already had a transformative effect on economic sentiment. His more energetic approach to policy, including the changes at the BoJ and the accompanying weakening in the yen, have led consumers and many firms to believe that the more accommodative macroeconomic policy settings will indeed help boost growth and inflation. And this improved sentiment was evident in many of the new data released over the past few days:

  • Following a rise in consumer sentiment to its highest since 2007, household spending rose for the second successive month in February, and by more than 2%M/M, suggesting that private consumption made a solid contribution to GDP growth in the first quarter of the year.
  • The BoJ’s latest Tankan survey suggested that business conditions for large manufacturers improved in the first quarter of the year. And the headline manufacturing index is expected to rise further in Q2 to a four-quarter high. And Japan’s non-manufacturers are even more optimistic, with the headline index anticipated to rise this quarter to its highest level since June 2008.

But with countless recoveries over the past two decades having come to nothing, signs of greater confidence hardly mean that recovery is assured. Indeed, the handful of disappointments also evident in the latest data served as a reminder for the Policy Board to avoid half-measures this week:

  • While manufacturers continue to forecast a rebound in output in March, surprisingly their output declined 0.1%M/M in February. And the BoJ’s Tankan survey flagged that conditions have deteriorated for many SMEs, particularly in the manufacturing sector, amongst which pessimism still reigns. 
  • Despite expecting rising sales and profits, the Tankan also suggested that firms currently plan to cut fixed investment in the coming fiscal year and see no notable improvement in the labour market over the near term. 
  • Firms also appear yet to be fully convinced that the BoJ really means business, forecasting an average exchange rate of around ¥85/$, about 10% stronger than its present level over the coming fiscal year. 
  • All the while, deflation persists, with headline CPI dropping 0.4ppts to -0.7%Y/Y in February, the weakest since August 2010, and underlying inflation (excluding food and fuel prices) down to -0.9%Y/Y. Wages continue to decline too, also down 0.7%Y/Y in February.

There therefore seems little reason for the BoJ to revise significantly its forecast that underlying inflation will significantly undershoot its target over the policy horizon. And so, despite the reticence of many Policy Board members over recent months to take more aggressive action, we expect Kuroda and his two new deputies to persuade a majority to back a significant overhaul of BoJ policy. In particular, we expect:

  • The BoJ to commit to increase its purchases of public and private sector securities by about ¥20trn over the coming year. That would imply bringing forward and augmenting the ‘open-ended’ asset purchases which it has already committed to undertake from the start of 2014. 
  • A pledge to buy longer-dated JGBs under its asset purchase programme. At first, it is likely to purchase JGBs with a residual maturity of up to five years, but it also seems set to signal a readiness to move further along the curve (up to ten years) in due course by considering a merger of its asset purchase programme with its ‘rinban’ operations of longer-term JGB purchases. That would also imply tearing up its self-imposed ‘banknote rule’ that has constrained its purchases of longer-term JGBs. 
  • Most of the additional purchases will be in the form of JGBs, to be bought at a rate of ¥3trn or more per month. But more purchases of private sector securities can be expected, including from entities with lower credit ratings. It may also relax its implied ‘1% rule’ under which its purchases of ETFs are conducted only when the TOPIX has fallen by that amount from the previous day’s close.
  • Stronger forward guidance, with a new Fed-style commitment to keep rates low for longer, perhaps until the 2% inflation target is in sight.

With market expectations so high, even the multi-faceted approach we expect risks triggering disappointment. In particular, with the BoJ likely to eschew JGB purchases at the long end of the curve where yields have fallen most in recent weeks (20Y yields have dropped more than 40bps over the past two months), the announcement might prompt some steepening of the yield curve. But the additional JGB purchases should justify the recent compression of yields at the shorter end. And since the expansion of the BoJ’s balance sheet that we expect (an extra 4% of GDP this year) will comfortably outdo any equivalent moves at other major central banks over coming quarters, the announcement should justify recent equity market gains and renewed yen weakness.

More important than the immediate market impact will be the longer-term economic impact. In particular, will the new policies be sufficient to meet the BoJ’s inflation target over coming years? We think not. Given the extent to which deflationary expectations are firmly entrenched, more accommodative monetary policy will need to be bolstered with additional support from fiscal policy beyond the present fiscal year to sustain above-potential GDP growth and close the output gap. Further structural reform initiatives, particularly to change the incentives for firms to invest, recruit and reward their staff, are likely to be required too. And, ultimately, we would expect to see more easing from the BoJ in the months ahead. Nevertheless, if the BoJ does as we expect tomorrow, it will mark a step in the right direction and help maintain some expectations of better times ahead for Japan’s economy.


Chris Scicluna, Head of Economic Research

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