The Bank of Japan in a bind
As inflationary pressure mounts around the world, all central banks – with a few notable exceptions – have moved the direction of monetary policy towards greater tightening, embarking on a relentless fight against rising prices. For example, the US Federal Reserve (Fed) has just raised its rates for the second time in a row by an almost unprecedented 0.75%. One of the exceptions is the Bank of Japan, which – despite the first signs of inflation in its region and a very depressed yen versus the US dollar – has not changed course, sticking with extremely expansive monetary policy. How can we explain this?
History provides part of the reason. For three decades, Japan has suffered from a long period of stagnation and deflation, caused by the various crises afflicting its economy since the early nineties after the bursting of the twin speculative bubbles in stock markets and real estate. This unprecedented situation forced the Japanese central bank to respond with equally aggressive and unconventional measures. It did so firstly by gradually cutting key rates to zero, and then by implementing the first programme of asset purchases – referred to as quantitative easing (QE) – with a view to injecting liquidity. Accordingly, Japan now finds itself with a stratospheric level of public debt of 250% of GDP. This is a heavy burden that leaves very little room for manoeuvre. The Japanese government cannot currently afford a high cost of debt servicing. The Bank of Japan is therefore adopting a yield curve control policy that consists in proactively buying government bonds in order to cap yields at very low levels.
The return of inflation in Japan is far from alarming so far, as it remains very moderate at below 3% and wage growth is under control. This development could even be considered good news for the Bank of Japan, as it represents a configuration that it has targeted for years. Furthermore, if we take a close look at Japanese inflation, price rises are primarily due to exogenous and volatile criteria such as the price of energy and agricultural products. As the pricing pressure driven by global demand for commodities appears to be starting to falter, this inflation could be eliminated in a matter of months or quarters.
However, such inflation, which is essentially imported, cannot really be considered healthy, as it results neither from strong growth nor from domestic demand. The other worrying factor is the Japanese currency, as the yen recently hit its lowest level versus the US dollar in 24 years. This situation is due to the ever-widening gap between the monetary policies of the Bank of Japan and the Fed. If the yen remains weak, this could result in further inflation and slow the Japanese economy, which is struggling to get back to pre-Covid levels.
All things considered, the Bank of Japan is facing a serious dilemma – whether to stick to its yield curve control policy in the hope that inflation will fall, or to increase its rates at the risk of undermining its already struggling economic momentum. What is certain is that the Bank of Japan seems happy to live with this delayed reaction, as does the ECB. This may well foreshadow the structural bind in which G7 central banks are caught, being increasingly held hostage by low interest rates. The ECB still has zero interest rates at the moment, whilst inflation is running at 8.6%. After a recent hike in rates to 2.50%, statements from the Fed are already starting to indicate a shift in direction, despite inflation of 9.1%. Can developed countries as a whole afford to raise rates on a sustainable, but more importantly, effective basis? Time will tell, but we have our doubts.
Final version of 29 July 2022 – Olivier de Berranger, Chief Investment Officer and Deputy CEO, La Financière de l’Echiquier
The information provided is the result of internal analyses based on the best publicly available sources available to us. They are carried out by the fund management team as part of its activity of managing UCIs and not a financial analysis activity within the meaning of the regulations. They do not constitute investment advice. La Financière de l’Échiquier assumes no liability for the accuracy or fulfilment of its forecasts.
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