Japan’s Monetary Policy
11 min read
While the world is struggling to battle inflation with tighter than ever monetary policies, Japan seems to be cruising by with their ever-so-loose strategies. At least for now. In today’s monthly article, we dive a little deeper to find out about the rationale behind Japan’s choice in monetary policy that seems to be contrary to the rest of the nations.
In a nutshell, everyone is pursuing a tightening approach to curb the soaring inflation that has plagued nations in the last couple of months. Things do not seem to be taking a turn, and the US Federal Reserve is gearing up to continue its aggressive stance, with admirable persistence, despite the large number of its citizens struggling with the high interest rates and increased prices.
Japan’s choice of action
The interesting news is that Japan seems bent on maintaining its ultra-loose monetary policy even in such a climate. This is largely because the global inflationary trend has not affected the country’s economy as much. In fact, Japan has had 15 years of experience with deflation, and this has kept its wage growth pretty much subdued.
Japan’s core consumer inflation hit 2.1% for two consecutive months in May, but the rise was mostly due to soaring energy prices. While core inflation may hover around 2% for the year, it is likely to slow to about 1% in the next fiscal year beginning in April 2023, according to Governor Haruhiko Kuroda. Kuroda has also claimed the Japanese economy, unlike the others, has not been much affected by global inflationary trends, hence the insistence on an accommodative monetary policy. This is also a result of Japan’s 15-year deflation lasting through 2013, and now firms in the country have become very cautious in raising prices and wages.
Kuroda has stressed that there is a need for Japan to maintain extremely low interest rates until inflation is driven more by stronger demand. This is the reason the Bank of Japan (BOJ) is now known as the outlier amidst this global wave of central banks hiking interest rates to curb surging inflation. Let’s now take a closer look at BOJ’s view of the economy.
BOJ’s view on Japan’s economy
According to BOJ, the Japan economy is likely to recover as the impact of COVID-19 and supply side constraints are starting to wane. Coupled with the support from an increase in external demand, as well as accommodative financial conditions and the government’s economic measures, the recovery of Japan’s economy seems viable. We do expect some downward pressure due to the rise in commodity prices, especially with the situation surrounding Ukraine. This is because Japan relies on imports from most of these commodities, like crude oil, natural gas, coal and grains. Rise in these prices brings about an outflow of income from Japan and downward pressure on households’ real income and corporate profits. However, the government’s measures against oil price rises and the accumulation of household savings (due to previous pandemic related restrictions) are expected to mitigate the downward pressure on income and the consequent negative impact on spending. Furthermore, a self-sustaining increase in demand, that includes pent-up demand, is projected to continue in both the households and corporate sectors. As such, BOJ projects the country’s economy to continue growing at a pace above its potential growth rate, albeit more slowly, with the negative impact of high commodity prices lessening and the virtuous cycle from income spending gradually intensified.
The bank has also projected earlier in April this year that the year-on-year rate of change in the consumer price index (CPI) is likely to increase temporarily to around 2% in fiscal 2022, due to the impact of increased energy prices. Subsequently, the rate of increase is expected to fall because the positive contribution of the rise in energy prices to the CPI is likely to abate. In the meantime, the year-on-year rate of change in the CPI is anticipated to only moderately climb on the backdrop of improvement in the output gap and increases in medium- to long-term inflation expectations and wage inflation, and partially also of a pass-through of raw material cost increases, especially to food.
Based on the financial conditions depicted by the outlook above, BOJ will continue to remain accommodative and pursue Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve control, which will support an increase in private demand. The environment for external funding, such as bank borrowing and the issuance of commercial paper and corporate bonds, is projected to remain accommodative as well. The financial positions of businesses, including those of small and medium-sized ones, for which weakness has persisted to date, are also likely to continue improving on a trend in tandem with an economic recovery, supported by the Bank’s financing support measures, the government’s measures and efforts made by private financial institutions.
Japan is also working towards a positive transformation in the post-COVID-19 era through accommodative financial conditions. With productivity increasing due to advances in digitalization and investment in human capital, as well as the acceleration of capital stock growth as a result of the rise in business fixed investment, the potential growth rate in Japan is also expected to rise moderately.
Risks Japan’s economy may face
Despite the relatively positive economic outlook BOJ has for Japan’s economy, there are certain factors taken into consideration when the central bank concludes that a loose monetary policy befits their current situation.
First, the impact of the pandemic on private consumption and export and production activities of firms may present an issue for the country. Depending on how well controlled the situation with COVID-19 is in Japan, the economic scenario unfolding could present very different outcomes for Japan. On the one hand, with persistent vigilance against COVID-19 and people being less willing to go out, there is a risk that the materialisation of pent-up demand could delay and private consumption may remain low. On the other hand, as vigilance lessens and private consumption resumes, supply side constraints could become prolonged and amplified. The resurgence of the virus at home and abroad could also result in strict measures being enforced at home and in other nations again, causing Japan’s exports and output to be pushed down and the negative effects could even spread to consumer spending and fixed investments in businesses.
Second, if high commodity prices persist, Japan’s economy could deviate downward from the baseline scenario at present through deterioration in terms of trade. This is largely because the rise in commodity prices due to supply factors is not accompanied by an expansion in external demand or an increase in exports. As an economy of commodity importers, Japan would face issues like an increase in import costs. Conversely, should geopolitical tensions start easing up, we can expect these prices to decline significantly, and the economy could move upward through an improvement in terms of trade.
Third, BOJ considers the developments in global financial and capital markets, as well as in overseas economies. With the surging inflation in many nations worldwide, global conditions are tightening more than expected, and interest rate hikes are the main solution so far. There are also adjustments in risk asset prices and capital outflows from emerging economies. If this continues, there is a likely risk that overseas economies will move downward from the baseline scenario. To top it off, there are also signs of a slowdown in the Chinese economy due to factors like adjustments in its real estate sector, with medium- to long-term growth potential declining gradually.
Finally, a factor considered from a long-term perspective would be the growth expectations of firms and households in Japan. The post pandemic era, coupled with digitisation and decarbonisation, is predicted to affect Japan’s economic structure and consumers’ lifestyles. Households’ and businesses’ expectations for medium- to long-term growth, the potential growth rate and the output gap could all alter depending on how they respond to these changes.
Taking into account all these risk factors and the possible economic scenarios that could play out, Japan has decided on the stance of an accommodative monetary policy upon weighing their options. The “Price Stability Target” principle was also taken into consideration when making this decision.
Price Stability Target
BOJ follows the “Price Stability Target” principle closely in terms of its conduct of monetary policy. This principle was first adopted in February 2012, whereby “price stability” is defined conceptually as “a state where various economic agents including households and firms may make decisions regarding such economic activities as consumption and investment without being concerned about the fluctuations in the general price level”. The newly introduced “price stability target” is the inflation rate that BOJ judges to be consistent with price stability on a sustainable basis. Based on this recognition, BOJ sets the “price stability target” at 2% in terms of the year-on-year rate of change in the CPI.
It is essential that BOJ assess the economic and price situations by examining the baseline scenario of the economic outlook for the country. The year-on-year rate of change in the CPI is likely to increase gradually but as of now, it remains at 2%. Overheating has not yet been seen in asset markets and financial institutions’ credit activities. Japan’s financial system has maintained stability on the whole, despite the pandemic. Even in the case of adjustments in the real economy and global financial system, BOJ assesses that the financial system of Japan is likely to remain highly robust in general, mainly because financial institutions have sufficient capital bases.
In terms of monetary policy, the central bank will continue to implement QQE with Yield Curve Control with the goal of achieving the 2% price stability target for as long as it is required to sustain the target over time. It will keep increasing the monetary base until the observed CPI exceeds 2% and will continue maintaining the target in a consistent manner.
A Trader’s View
For once, BOJ is doing something different from the rest of the world. Standing at 2.1%, Japan’s inflation rate is far from the others. For example, the inflation rate of the USA stands at 8.6% and the UK, at 9.1%. Although they have finally achieved the 2% inflation target, this was mainly because of external factors like supply constraints, price in commodities and rising energy cost. What BOJ wants is an inflation due to domestic factors and structural reforms instead. However, at the current juncture, BOJ can’t stop its ultra-easy monetary policy. Probably the right time for them to stop easing may come in the next two to three years, as the economy gains the power to self-improve with individuals and companies working hard to better their situations.
Although Japan’s central bank has been under fire for failing to strengthen the economy sufficiently to achieve inflation of 2% because of internal issues, within a year of quantitative easing, BOJ policy lifted Japan out of deflation and stabilized prices. Japan continued to endure the second-longest postwar economic expansion as the job situation began to improve. We might even claim that the BOJ’s actions helped Japan’s economy grow by “easing.”
The currency in focus this month is CHF/JPY. Since we know that BOJ will continue their ultra-easy policy, let’s find some trade setup that fits the weak Yen. Based on technical analysis over a few currency pairs: USD/JPY, CHF/JPY, GBP/JPY and EUR/JPY. CHF/JPY is the one that has a potential setup to buy. Let’s take a look at the daily chart. Based on support and resistance on the channel, it bounces off a couple of times, proving it to be a support. Coupled with the higher low and lower high, this is a confirmation of an up trend movement. At current level 139.12, we could do a Buy order based on the support of the channel. But it is always better to wait for a confirmation candle like bullish engulfing or morning star formation before entering the market. This way, we will have a better chance of taking profit.
