BOJ: The 80 Trillion Yen Question

The Bank of Japan July policy meeting ends tomorrow (Friday 29 July), and markets remain divided as to its outcome.   Although expectations of easing are building (including, according to Nikkei reports, within the BOJ), we see reasons why the BOJ may choose to adopt more symbolic (and hence modest) easing measures than markets expect.
Earlier this week, markets were not greatly surprised by the Fed’s upbeat tone on 27 July, as the FOMC left rates on hold, judging that  “[n]ear-term risks to the economic outlook have diminished,” , but they did boost expectations of a rate hike within this year.

Probability-of-Overnight-Target-Rate-Level-14-December-Current-Probability-Previous-Day-Probability-_chartbuilder

Were the BOJ to ease tomorrow, divergence in monetary policy would probably support USDJPY, thereby assisting Japanese stocks.

Indeed, the Nikkei newspaper, often perceived as a forum for strategic media trial balloons in advance of policy decisions, claims that support for further easing is growing within the BOJ.  There has certainly been political pressure for easing from the government as well as from the Japanese Business Federation (Keidanren).

If the BOJ does ease, it has several options in terms of operations.  Its options include (a) cut marginal rates from -0.1% to a more negative overnight rate target (b)   increase purchases in one or several asset classes from current levels (JPY80trn annual in JGB’s; JPY3trn in ETF’s; JPY90bn in J-REITS) (c) further lengthen the average maturity of holdings (on average somewhere between 5 and 7 years by our estimates) (d) apply forward guidance with respect to its balance sheet or (e) an extreme derivative of (d)) espouse a “helicopter drop” strategy, wherein the BOJ offers unlimited monetisation of government debt.  Option (e) remains extremely risky given the massive levels of outstanding government debt (and potential for fiscal crisis) and therefore low in probability in our view, but the idea came to the fore in investor consciousness after the BOJ held meetings with former FOMC Chairman Bernanke, credited for applying the idea of “helicopter money” to deflation-fighting in central bank policy.

However, in terms of effectiveness, the difficulty the central bank has experienced in compelling expectations for price rises remains a depressing factor.  As such, there are arguments for the BOJ to hold fire until it can deliver a more effective surprise.  In order to gauge what an effective surprise is versus an ineffective one, we only need compare the outcome of the “Halloween surprise” of October 2014 to the introduction of NIRP in January.  The “Halloween surprise” appears to have been much more effective given the subsequent drop in the yen, the boost to stocks and, importantly, boost to prices while NIRP brought with it cash hoarding and other unintended consequences.

Meanwhile, the government is also attempting to boost sentiment via the “second arrow” of Abenomics, fiscal policy.  And although fiscal stimulus package “leaked” in the Nikkei Wednesday (JPY20trn, with JPY6trn of “real water”) appears to have had a supportive impact upon stocks by weakening the yen, even at its most generous, the supplementary budget for this fiscal year is likely to total only JPY2trn, with additional stimulus spaced out over the coming years, and most of this dedicated to public works (which, many fear, runs the risk of turning into wasteful spending rather than a monetary-plus-fiscal stimulus powerhouse).

In making their decision, the BOJ is likely to consider its impact upon the market as well as price expectations; it will ask whether a boost to dollar-yen and the Nikkei that would accompany additional monetary stimulus would last long enough to justify the increasing costs and risks of easing; each of the above strategies is associated with both.  A rise in JGB purchases, for instance, would risk decreasing liquidity in the JGB markets even further and the purchase of a greater amount of JGBi’s would further dilute the information content of this product’s price on inflation expectations.

And future inflation expectations, rather than actual inflation, is what the BOJ may hope to influence.  On this front, a few several indicators show that the BOJ might have little to gain by easing further now (particularly given the rise in expectations of Fed tightening once again); that there are advantages of keeping its powder dry.

One of these is the ongoing low unemployment rate.  Japan’s NAIRU (non-inflation accelerating rate of unemployment), which sits above 3%, very near the current unemployment rate of 3.2%:

PhillipsCurve

However, wages have failed to accelerate, one reason why the BOJ’s reflationary efforts have failed to take off:

japan-wage-growth

On the wage front, we also note the government’s recommendations to raise minimum wages, which in the current environment of low unemployment, might actually prove inflationary.

In this case, further easing may prove redundant.   Going back to the “Halloween surprise” comparison, we observed that the U-Tokyo CPI indicator (a “nowcast” of daily inflation using scanner prices at grocery stores) was greatly under-performing its “official” index component in October 2014.

UTokyoCPINowcast

Importantly, although the CPI grocery component was positive y/y, the daily indicator was negative.  Since inflation expectations tend to be autoregressive (dependent on recently realized inflation), the BOJ’s surprise was timely and therefore successful.  Looking at the indicator today however, we do not see the same deflationary dynamics:
CPIdaily_s

On their own, these are arguments for the BOJ to hold fire tomorrow.

Still, the combination of pushing dollar-yen higher via clear divergence in BOJ policy from the Fed’s, combined with mounting market expectations for BOJ action might be too difficult to resist.  In the instance BOJ does ease tomorrow, we would expect easing to favour a modest rise in risk assets (ETF’s and REITs) and possibly in JGB’s, rather than “helicopter drops” of cash.   We see the risks of greater than symbolic easing as elevated, and aside from a temporary boost to equities and dollar-yen, the benefits not so clear-cut.

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