Blades Whirring Over Japan?

Japanese central bankers are not in an enviable position. The year-over-year growth rate of the country’s core consumer price index was -0.4 percent in May, marking the third consecutive monthly decline—and this after three years of Abenomics.   Brexit certainly hasn’t helped. The yen has strengthened from ¥121 to the dollar in February 2016 to ¥105 in late July. That’s had the effect of reducing import prices, but it has also put downward pressure on inflation. Japan economists on Credit Suisse’s Global Markets team believe it would have to weaken to ¥140 for headline inflation to reach 0.5 percent. But that’s unlikely. Given the post-Brexit volatility in financial markets and the yen’s status as a safe-haven currency, Global Markets foreign exchange analysts expect the currency to go the other direction, strengthening to ¥100 over the next three months and ¥95 in the next 12 months.   Other deflationary forces are homegrown, in particular the country’s inability to address the many demographic forces that are working against inflation. Whatever the causes of the problem, mind you, Credit Suisse believes the conclusion is the same: Having failed to raise inflation expectations with negative interest rates, the Bank of Japan needs to take more drastic measures to lift the island nation out of its deflationary state. Financial pundits have been speculating that the central bank will turn to “helicopter money,” through which it can fund either government spending or tax cuts by permanently expanding the monetary base. In practice, the Bank of Japan would either print new money to buy the newly issued perpetual Japanese government bonds, which don’t have a maturity date, a process that would require the central bank to buy bonds directly from the Ministry of Finance. The central bank could also buy ordinary government bonds in the secondary market and promise to either hold them forever or keep rolling them over in perpetuity.   And therein lies the rub: The key to making helicopter money work is convincing the public that the promise is real, and that the expansion of the monetary base really is permanent—that the central bank won’t someday sell its government debt holdings in order to reduce the monetary base. When a central bank owns a country’s bonds, they have ceased to be a true liability; it’s money Japan owes to itself. But if the central bank sells its holdings in the secondary market—or even if market participants believe it will do so eventually—those liabilities become real again. And if that happens, the private sector is likely to anticipate future tax hikes to repay the debt and reduce its own spending accordingly.   But drastic does not necessarily mean imminent. It seems highly unlikely, in fact, that the country’s central bank will set the helicopter aloft anytime soon. For starters, they’ve said as much: Bank of Japan Governor Haruhiko Kuroda said recently that helicopter money was neither necessary nor a viable option. And even if they decide to do so, there’s the matter of the red tape. Japanese law prohibits the central bank from purchasing new government bonds directly from the Ministry of Finance, as opposed to purchasing them in the secondary market, which it does in its current quantitative easing program, unless “special reasons exist” and the Diet must approve the spending. While politicians can certainly relax the laws, they haven’t moved to do so yet.   Credit Suisse expects an announcement this week of a ¥28 trillion multi-year spending package by the government, which is likely to include infrastructure development, financial support for small businesses, expanding entitlement programs (by lowering the threshold for the number of years a person has to work to receive social security, for example), and disaster prevention measures. The Bank’s Japan economists expect limited economic benefits, however—around 0.2-0.3 percentage-point average increase in GDP for several years following the launch. The package is expected to rely heavily on investment and credit expansion of quasi-government organizations as well as commercial banks, and the expected government bond issuance to fund the package will be rather small. This reflects the Abe administration’s remaining reluctance to increase the budget deficit.   The Bank of Japan (BoJ) policy board decided to almost double the amount of equity ETF purchases at its July 29 regular board meeting, reportedly amid very strong, last-minute political pressure. It left the targets for the monetary base expansion and JGB purchases unchanged, however. Interestingly, the central bank’s policy board hinted at the possibility of a revision in the monetary policy framework at the next meeting in September, which would be a kick-off of a new kind of fiscal-monetary accord. Crucially, for the accord to be effective, the central bank would have to increase its inflation target rate to between 3 and 5 percent. Credit Suisse believes the existing ¥80 trillion-a-year quantitative easing program has fallen short because the central bank’s 2 percent inflation target essentially signals that the BoJ will reign in its asset purchases just as inflation gains a toehold.   At the same time, a new accord could see the Japanese government significantly increase the proportion of longer-dated bonds (20-to-40 year maturities) it issues, while the Bank of Japan would periodically lengthen the average remaining maturity of its bond purchases. The BoJ would also raise the percentage of outstanding government bonds it holds closer to 50 percent and commit to maintaining that percentage even after reaching the upper limits of its new inflation target and commencing rate increases.   According to Credit Suisse for fiscal-monetary coordination to succeed, the central bank must signal that it will tolerate significantly higher levels of inflation before reining in bond purchases. The fiscal-monetary accord that Credit Suisse thinks is possible would not be helicopter money in the sense of permanent quantitative easing through either the purchase of perpetual bonds or the commitment to roll over government bonds in perpetuity. But in a country where deflation has been an ever-present threat, and occasionally a reality, for three decades, it’s a step closer toward the kind of reassuring Mario Draghi-style “whatever it takes” moment that Japan needs to get prices moving higher.