Can Ueda lead Japan out of these difficult times?
10 min read
About a decade ago, Bank of Japan (BOJ) Governor Haruhiko Kuroda introduced negative interest rates in his unprecedented monetary easing policies. The BOJ’s massive stimulus measures, which were often called the “Kuroda Bazooka” by market participants, drove down Japanese Government Bond (JGB) yields, causing banks to undertake significant portfolio adjustments.
In April this year, Kuroda will hand over the reins to Kazuo Ueda, who will then have to tread a fine line to achieve a delicate balance between alleviating the adverse side effects of the existing policy and promoting growth in the country.
Mistakes of the past
In the March issue of the International Monetary Fund’s quarterly magazine, former BOJ governor Masaaki Shirakawa said that Kuroda’s “great monetary experiment” over the past decade had only “modest” effects on inflation and growth. In his opinion, the stagnant growth of Japan was brought on by structural issues, including ageing and a diminishing population, which was mistaken for cyclical weakness, leading to the long-drawn easing.
With the prolonged easing in Japan, negative effects on productivity growth through misallocation of resources started to happen. This was because monetary policy was used as a quick fix for structural problems that actually needed more drastic reform. Other notable magazine contributors also expressed caution about an overreliance on easing.
The risks of inflation from an overheated economy may be far higher than previously believed, but quantitative easing might not always have positive effects on real activity. In fact, as long as low inflation doesn’t collapse into a deflationary spiral, central banks should not have to worry excessively about it. Japan’s economy and labour productivity were not hampered by years of low inflation. It was the smaller labour force and an ageing population that were more to blame. Yet, the country has been on an ultraloose policy for a long time. That being said, a quick exit from easing would not be able to resolve Japan’s economic woes as well. Curbing recent trends, like a wage gain, could instead even prolong the need for easy policy.
Ueda’s take on the matter
Ueda’s main role is to reverse the unconventional monetary policies that his predecessor had implemented, such as yield-curve control, equity purchases, and negative interest rates, so that Japan can focus on the underlying causes of its economic stagnation, such as slow productivity growth, an ageing and declining population, and a loss of economic dynamism.
Ueda has been viewed as the perfect fit for the job of BOJ governor. As a non-ideological pragmatist, he is able to straddle the ideological divides in economics. Ueda said at a news conference at the end of February that he thinks the current policy rate is appropriate, and he agrees that rushing to raise interest rates because of a temporary rise in inflation would hurt the economy and inflation rate of the country. However, he also acknowledged that failing to handle the weak yen would magnify the negative consequences of rising dollar-denominated food and energy prices. This showed how he understood both sides of the argument. He also came to the conclusion that the future of Japan’s unusual monetary policies, which have lasted longer than most people thought they would, will need to be seriously considered at some point.
A glimpse into Japan’s Lost Decade
Perhaps it would be helpful to first find out a little about Japan’s economic history to help put matters into perspective. The Lost Decade was a period of economic stagnation in Japan caused by the asset price bubble’s collapse in late 1991. The term was first used to describe the 1990s, but as the trend continued, commentators began to include the 2000s and 2010s as well. Following the years of stagnation and a banking crisis in the 1990s, policymakers were desperate to try anything, and Ueda took the front-row seat for Japan’s first experiments with radical monetary policy. He also assisted in managing the implementation of a policy of zero interest rates in 1999 and significant monetary expansion in 2001.
During the Lost Decade, Japan’s economic problems reflected a failure to deal proactively with the impact of the collapse in asset prices in the early 1990s. Japanese stock values fell 60% by mid-1992 after the 1990 bubble implosion. Land prices fell a year after stock prices plunged, although their decline was more gradual. The drop in asset prices hurt loan collateral and lowered bank capital, first by wiping out hidden gains on stock holdings and then directly through the new mark-to-market procedures. After the economic slump, firms that borrowed significantly to pursue aggressive business strategies in the bubble years had massive surplus debt and capacity.
During a protracted period of lacklustre development, several conflicting explanations have emerged to explain the poor performance in Japan. Some economists are of the view that financial institutions played a central role in increasing the economic impact of asset price declines. Bank lending, directly and through a self-reinforcing cycle with land and stock values, drove strong growth in the second part of the 1980s. Once asset prices fell, undercapitalised banks slowed lending to meet capital requirements. Due to banking sector funding constraints, individuals and enterprises were unable to respond to monetary and fiscal stimuli. Other analysts suggest that productivity fell sharply due to the conventional Japanese economic model’s inability to adjust to a more deregulated and competitive world economy. There are also pundits who propose a third explanation: Japan’s liquidity trap, with nominal interest rates unable to fall below zero and real interest rates too high to promote economic activity, caused the crisis. As a result, low interest rates as a tool of monetary policy became ineffective. During most of the 1990s, the BOJ’s discount rate was 0.5%, but it didn’t help the Japanese economy grow because deflation kept going on. Of course, these explanations are not mutually exclusive.
Basically, the central bank’s monetary easing at the time was unprecedented in scope. Central banks were often expected to “lean against the wind”, loosening or tightening money supply as needed to avert financial catastrophes. Yet, it foreshadowed the widespread acceptance of crisis management through ultraloose monetary policy in many industrialised economies that was to come thereafter: Central banks all across the world flooded their economies with cash in the wake of the 2008 global financial crisis and once again after the pandemic. The loose monetary policy of the BOJ looked to fit right in.
However, that abruptly came to an end when US inflation increased last year, and since then, monetary hawks, who prefer tighter monetary policy and higher interest rates, have prevailed in most developed economies across the world, with the exception of Japan. The benchmark interest rate of the US Federal Reserve has been increased by 4.25% through 2022, but the BOJ, led by Kuroda, has so far refrained from doing the same. The currency markets have been wrecked as a result. Late last year, Kuroda was in charge when the yen fell to an all-time low against the dollar, reaching 23% at one point.
In any case, most analysts think that it does not really matter who takes over Kuroda; changes to the existing monetary policy framework are inevitable. As we start to see sharp drops in the value of the yen and rising consumer inflation, the negative effects of the policy are already starting to outweigh the positive ones.
The difficult time in Japan
Kuroda was supposed to end his longest-serving BOJ governor record with a bang, but there was a surprise twist in the final year of his reign. Inflation erupted in 2021 in the US, which had a similar expansionary monetary policy history with Japan that started during the pandemic. Consumer inflation in the US reached 6.8% in November last year, which was the highest level in nearly 40 years. As inflation began to erode President Joe Biden’s support, worries grew within the White House, and pressure mounted on the Fed to act.
Russia’s invasion of Ukraine in February 2022 also served to make matters worse when it led to global shortages of food and energy. Commodity prices skyrocketed, and consumer inflation rose. All these resulted in the Fed beginning its most aggressive tightening campaign in 40 years, hiking interest rates all the way through 2022. However, with Kuroda’s insistence on maintaining a zero-interest rate policy in Japan, it triggered a significant shift in financial flows away from Japan as investors sought higher returns in the US, thereby putting the yen under tremendous pressure and resulting in the depreciation of the yen. Bond rates widened as the weak yen increased inflation in Japan, making the BOJ’s low-interest-rate strategy increasingly unworkable.
Late last year, Japan’s inflation went up, but it wasn’t because the economy was doing better. Rather, it was owing primarily to an increase in import costs: domestic prices rose 4.0% in December 2022, a 41-year high, compared to a 0.5% increase in January of the very same year. Kuroda emphasised that the BOJ did not need to tighten policy because inflation in Japan would be temporary and a weaker yen would be more beneficial for exports and the Japanese economy. This sparked a clash with the market, which had short-sold government bonds in the assumption that Kuroda’s strategy would be unsustainable and the BOJ would cave in.
Kuroda refused to back down, even when the yen fell to 151 per dollar in October, a 32-year low, leading the Finance Ministry to launch the largest yen-buying intervention in history. The yen has now recovered ground as investors reduced their expectations for additional monetary tightening in the US. Nonetheless, upward pressure on Japanese government bond yields continued as traders thought that yields were still set too low, pushing the BOJ to increase asset purchases to keep yields down.
The BOJ appeared to eventually relent in December, allowing 10-year rates to vary between plus or minus 0.5% around zero rather than 0.25%. Kuroda stated that the decision was made to facilitate smoother financial market transactions. Even though the bond market hasn’t been working well for a long time, the BOJ didn’t do anything else at its monetary policy meeting on January 17 and 18. This left the markets confused about Kuroda’s plans.
On the one hand, the BOJ maintained its easing bias in its policy statement, committed to keeping interest rates at current or lower levels. On the other hand, the bank expressed concerns about the bond market’s persistent “dysfunctions,” implying that no one would buy bonds other than the central bank.
In the end, it is clear that Japan’s ultraloose monetary policy can no longer work in the world we live in today. As Kuroda passes the baton of BOJ governorship to Ueda, we should expect Japan’s economic situation to improve, though it will take some time. With so much government debt on its balance sheet, the BOJ will have to move slowly toward normalising policy so as not to cause a shock to the economy. If interest rate hikes are too sudden and sharp, it would result in severe implications for the economy. Ueda should take his time and make changes in a more gradual manner. We need to remember that the BOJ should not be the main player in the economy. Its duty should be to support the economy in the background. This is what policy normalisation ought to mean.
A Trader’s View
Although BOJ loose monetary policy and bond purchases are expected to continue despite the constantly growing inflation, the recent change in BOJ tone gives rise to the possibility of an end to the loose monetary policy. We believe that the yen will continue to be strong in the medium term unless there are changes to the BOJ’s newly adopted stance.
RBA Governor Lowe has signaled a possible slowdown and eventually putting a stop to the rate hikes, which means a weaker AUD in the medium term is expected.
Personally, I prioritise pairing the strongest currencies with the weakest currencies over technical analysis, which is why I chose AUD/JPY. As shown in the day chart above, AUD/JPY tested twice on 50% Fib levels of its most recent swings, which indicates a strong price rejection. I expect the price to continue lower to test its recent low at 87.5; a break below the 87.5 could see prices tumble to 80.5.
