We recently spent some time on the ground in Tokyo meeting with counterparts. Attached are our views of developments in the economic outlook, current and prospective trends, and the policy framework, with a view towards Bank of Japan policy. As this note is merely a brief overview, please reach out if you’re interested in a more nuanced discussion as well. It would also be our pleasure to discuss BOJ policy further with you in person or over the phone.
• Potential growth is estimated to be 0.5%-1% currently, up from 0% from 2009 to 2011. That rise is partly a result of the increasing participation of women in the labor force and an upturn in current and projected productivity growth.
• As in the U.S., the cyclical strength of the Japanese economy has to be assessed in terms of how much actual growth exceeds potential growth, given the low rate of potential growth. • Over the past four and eight quarters, growth has advanced at a 2.1% and 1.8% annual rate respectively, above trend and consistent with an increasingly positive output gap and declining unemployment rate.
• The output gap is estimated to be around 1½%.
Labor Market Tight, but Wage Growth Remains Low
• The unemployment rate is 2.5%, and it has been in the range of 2½% to 3%, slightly below the BOJ’s estimate of the structural unemployment rate.
• The labor force is flat, but average hours are declining as a result of the increase in the labor force participation rate of women, who are more likely to work part-time.
• Firms (especially non-manufacturing) are responding to labor force tightness by introducing labor-saving technology, limiting the passthrough from the modest rise in wages to prices. • Wages of part-time workers are increasing at about a 2% rate, while wages for full-time workers are inching up at a ½% rate.
• Average earnings (including bonuses) are rising at a rate below 1%.
Inflation and Inflation Expectations
• BOJ policy board members project the CPI for all items less fresh food. When we look at the recent CPI data, we focus on the core CPI (prices excluding fresh food and energy) as the best measure of underlying inflation.
• While CPI inflation excluding fresh food is 1% over the past year, it has been boosted by rising energy prices. Core inflation is just 0.5%.
• The staff estimates that the increase in the consumption tax in 2019 will raise CPI inflation excluding fresh food by 0.5 percentage points.
• Board members project the CPI excluding fresh food, net of the effect of the increase in the consumption tax, will rise at a 1.8% rate in 2019. When discussing the timing of reaching the 2% inflation objective, the BOJ says it will be “around fiscal 2019.”
• There are many measures of longer-term inflation expectations. We focus on five-year-ahead expectations based on a survey of firms, which stands at about 1%.
Real Rates and the Natural Rate
• The BOJ staff’s estimate of the real neutral rate path looks remarkably similar to that for the U.S. (Laubach-Williams), declining from near-2% in 1995 to near zero by 2010. It’s remained near zero or slightly negative for the last few years.
• The degree of accommodation today, measured by how much the real rate is below the neutral rate, is very large relative to historical experience.
How the BOJ Expects to Achieve the 2% Inflation Objective
• The BOJ describes the transmission of monetary policy as
o first, through increases in the output gap, and
o second, via increases in medium- to long-term inflation expectations.
• The output gap is expected to rise in response to the decline in real rates. But the question is whether there any feasible further rise in the output gap would be sufficient to raise inflation toward the objective. This seems questionable, given the dramatically flatter Phillips curve today in Japan and elsewhere.
• The second way monetary policymakers can raise inflation is by raising inflation expectations, that is, by managing medium- to long-term inflation expectations through forwarding guidance aimed at “increasing credibility in the inflation targeting strategy.” The BOJ refers to this as the “reinforcement of commitment.”
• An example is the “overshooting commitment,” a commitment to continue to increase the monetary base until core inflation rises above the 2% objective in a stable manner. This commitment likely has little effect when inflation is as low as it is, but would become more impactful were inflation to rise meaningfully above 1%.
• Another example is giving speeches and post-meeting statements that reinforce the commitment to achieving 2% inflation on a sustained basis.
• Our favorite form of forwarding guidance is policymakers projecting inflation getting to 2% in a year or so when that forecast has been consistently off the mark!
• However, given that inflation expectations today are so adaptive, that is, tied to current inflation, it seems unlikely that the BOJ can “talk up” inflation to 2%.
• Growth is projected at a 1.4% rate in the 2018 fiscal year, about ½ percentage point faster than potential, consistent with the projected steady rise in the output gap. In fiscal 2019, growth is projected to slow to 0.7% in part as a result of the scheduled increase in the VAT.
• The key projection is for inflation. Policy Board members project CPI (excluding fresh food) inflation of 1.4% in fiscal 2018 and a rise to 1.8% in fiscal 2019, net of the effect of the rise in the consumption tax. Private-sector forecasts, on the other hand, are slightly below 1%.
The Monetary Policy Framework
• “The current monetary policy aims to facilitate the formation of a yield curve that is deemed most appropriate for maintaining the momentum toward achieving the price stability target of 2 percent.” • Specifically, the strategy calls for the BOJ to set and enforce a target for the ten-year JGB yield, along with a target for the short-term policy rate.
• The strategy is principally motivated by a desire to avoid a flattening of the yield curve that would put pressure on bank profits and bank lending.
• The BOJ states that it will continue with this yield curve control strategy, “aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner.” • We continue to find it awkward that the BOJ policy framework also references the monetary base. • There are two problems: First, the monetary base is endogenous under the yield curve control strategy, not an independent instrument. Second, the monetary base commitment is to overshoot the
2% inflation target, while the yield control strategy is only to reach 2 percent inflation in a sustainable manner.
The BOJ’s Monetary Policy
• The BOJ has set a target of zero for the ten-year JGB yield today.
• “The Bank will make policy adjustments as appropriate, taking account of developments in economic activity and prices as well as financial conditions…” This reads like a policy rule, emphasizing adjustments to the ten-year JGB target in response to economic and financial developments.
• The commitment is to the framework, not to the current setting of the target within that framework. This, of course, is the prevailing uncertainty about BOJ policy: For how long will it set a target of zero for the ten-year JGB, as the output gap continues to rise and inflation moves higher, even when inflation remains well below the 2% objective?
• The policy statement also provides an estimate of asset purchases, but this is an estimate best seen as consistent with hitting the ten-year target, rather than a separate target.
When Will Normalization Begin?
• Policy normalization, within the context of the policy framework, would begin with a gradual rise in the ten-year yield target. The BOJ appears confident it can begin to normalize rates smoothly under this policy framework.
• The most-discussed uncertainty in the markets is when normalization will begin. There seems to be an expectation that normalization will begin relatively soon.
• And that leads to a question of whether the BOJ will again prematurely begin policy normalization. • In response, the BOJ emphasizes that initially raising the ten-year target would not be an explicit “tightening” of policy, but rather a withdrawal of some of the extraordinary prevailing accommodation as the economy improves. The policy would remain accommodative, with the aim of raising the output gap further and raising inflation toward 2%, consistent with prescriptions of a policy rule. • Our interpretation is the BOJ policy is that: (1) Its policy framework will remain in place until it achieves its 2% inflation objective on a sustainable basis; (2) It will continue to raise the monetary base until inflation overshoots its inflation objective in a stable manner. (3) It will adjust policy in line with an implicit policy rule.
• The questions are whether (1) is consistent with (2). Does the BOJ really have a commitment to overshoot the 2% objective? And what economic conditions would result at the beginning of normalization? There appears to be no guidance about the second question and this keeps the markets on edge.
• The BOJ anticipates that inflation will rise at a 1.8% rate (2.3% including the effect of the consumption tax) in fiscal 2019.
• If inflation rises at a 1.8% rate in fiscal 2019, as the BOJ projects, it seems clear that the BOJ would at least begin to normalize rates next year, if not before.
• The yen has been rising since the beginning of this year, the counterpart of the depreciation in the dollar.
• This defies expectations and the relationship between exchange rate and relative long-term real rates, without a compelling explanation.
• One possibility that is sometimes mentioned is, given that Japan is one of the most-favored safe havens—even more so than the U.S.—uncertainties associated with Trump administration policies may have contributed to dollar appreciation and yen appreciation, which, if sustained, would put downward pressure on inflation.
• There has been some talk at the BOJ about purchases of Treasuries. This would be politically sensitive, particularly under the Trump administration. As such, we expect it is unlikely.
• Additionally, Abe’s grasp on power could become more tenuous with recent events. If there is a change in leadership in the fall, this could indirectly affect BOJ policy going forward.
• The real side of the economy is doing very well: Growth is above trend, the output gap is positive and rising, and the unemployment rate is low. Continued above-trend growth and further increases in the output gap, as projected by the BOJ, seem plausible.
• The question remains how responsive inflation will be to the rising output gap and whether inflation expectations will rise without an increase in core inflation to 1% or above. • The BOJ seems comfortable with its yield curve control policy, but the question is how long it will be prepared to maintain a zero target for the ten-year rate as the economy continues to improve and inflation rises in line with the BOJ’s expectations.