Japan: Front-Runner Of Outright Monetization

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Authored by Ryutaro Kono of BNP Paribas,

Democratic governments in low-growth economies sometimes rely on their central banks to support fiscal policy so as to avoid asking voters to share more of the burden. BNP Paribas' Ryutaro Kono notes that it is the pathology of modern democracies to foist our bills onto future generations and one could argue that the prolongation of our zero-rate regimes and quantitative easing are facilitating this. When this societal weakness is combined with today’s financialized economies, we get a pronounced inclination toward monetization, which could lead to very serious problems. While Governor Shirakawa has described the BoJ as the “frontrunner” in venturing into unknown territory with policies like zero rates and quantitative easing, Kono warns that Japan could also become the frontrunner of outright monetization.

Japan: The challenges facing a Kuroda-led BoJ

  • These past five years, the Shirakawa-led BoJ has been at the mercy of yen appreciation.
  • The Kuroda-led BoJ faces the not insignificant hurdles of defeating deflation and then smoothly exiting the current policy regime.
  • The massive JGB holdings purchased in the fight against deflation will inevitably entangle the BoJ in government debt management and this could constrain policy flexibility.
  • When inflation picks up in earnest, the BoJ may have to sacrifice price stability to ensure financial-system stability.

Shirakawa-led BoJ was at mercy of yen appreciation
In the five years of Governor Masaaki Shirakawa’s leadership, the BoJ was at the mercy of yen appreciation resulting from the aggressive monetary easing of the US and Europe in the wake of the global financial crisis. In the US, the main rationale for additional monetary easing was chronically high unemployment; in Japan, however, it has always been to counter upward pressure on the yen. That the yen remained strong was blamed on Mr Shirakawa, for not being as aggressive as his counterparts in the US and Europe. But, to some degree, currency depreciation in the US and Europe can be seen as an inevitable consequence of the bursting of their credit bubbles. History shows that the currency of a country experiencing a burst bubble tends to depreciate sharply; this then acts as a mechanism for an economic recovery, as the improvement in price competitiveness boosts export growth.

BoJ the scapegoat for past FX diplomacy failures
Yen appreciation has been aggravating Japan’s chronic deflation, so some monetary easing is called for. However, for Japan, which did not experience a financial crisis of its own this time around, aggressive monetary easing merely for the sake of preventing yen appreciation is not without problems. If yen appreciation were deemed fatal to the competitiveness of the exporting sectors, a response could have included more aggressive FX intervention by the government (MoF), rather than such heavy reliance on the BoJ, but this would have run into international opposition.

Policy development over the past few years has seen the government habitually make the BoJ the scapegoat for Japan’s ills because of its inability to convince its counterparts in the US and Europe of the need for yen strength to be corrected. In this regard, the initial stages of the Abe administration’s FX policy can be deemed a success, as its jawboning has led to a significant depreciation of the yen without stoking heavy international criticism. One could also argue, though, that the new government just got lucky and happened to come into power when the fundamentals (global risk appetite, the trade account) were shifting in favour of a weaker yen.

New BoJ leadership to strengthen JGB buying
That said, to keep up expectations of reflation, action needs to follow the words. And with explicit action to weaken the yen an unviable option because of diplomatic constraints, the BoJ will remain under pressure to do the heavy lifting. At the fist meeting under Haruhiko Kuroda’s leadership, we expect the BoJ to expand JGB purchases for this year by JPY 20trn and extend the duration of JGBs eligible for purchase from three years to five. Considering the rhetoric of the incoming central-bank leaders, more aggressive action certainly cannot be ruled out.

Indeed, while the 3-4 April meeting is the first scheduled board meeting under the new leadership, there is a chance that Mr Kuroda, who lends weight to the role of market expectations, could opt to convene an emergency meeting shortly after being formally installed as governor on 20 March and announce additional easing. In any event, we expect the BoJ’s asset purchases to be expanded progressively in the period ahead, both in scale and scope, with a good chance of the duration of eligible JGBs ultimately being extended to 10 years.

Forward guidance is also likely to be strengthened
The new BoJ leadership is also likely to consider strengthening its forward guidance. When inflation targeting was adopted in January, the policy statement was ambiguous on the conditions for lifting the “virtually zero interest rate policy”. Rather than the earlier forward guidance of “until it judges that the 1% goal [for price stability] is in sight,” the January statement adopted a vague “as long as the Bank judges it appropriate to continue with each policy measure”. To get the most out of forward guidance, wording along the lines of “until the inflation target of 2% comes into view” could be adopted as early as in April.

Will fiscal policy dominate monetary policy?
However, overcoming deflation is probably not the only challenge Mr. Kuroda will face. Another major issue for the new governor will be a threat of fiscal dominance. In a 1981 article entitled Some Unpleasant Monetarist Arithmetic for the Federal Reserve Bank of Minneapolis quarterly review, Thomas Sargent and Neil Wallace wrote that in an economy that satisfies monetarist assumptions (in which the monetary base supplied by the central bank determines prices – the quantity theory of money), price stability can be achieved if the central bank remains independent. But they argued that prices would be determined by the government’s fiscal stance if monetary policy were dominated by fiscal policy, wherein the monetary base was used for the government’s debt repayments, amid the prospect that future tax receipts could not retire the debt. This view has evolved into the fiscal theory of the price level.

BoJ is confronted with monetisation
In Japan, amid growing doubts about fiscal sustainability, not only have the government and BoJ jointly set a target for price stability, but political calls for the BoJ to conduct de facto monetisation have become mainstream. While monetisation can be effective in ending deflation, history shows there is a risk that it could destroy fiscal discipline. Whether this loss of fiscal discipline will actually lead to accelerating of inflation in the foreseeable future is a moot point. However, as the predicament in peripheral Europe has shown, bond yields can soar once the markets start to worry seriously about fiscal collapse (though Japan’s having its own currency reduces default risk). In Japan, a sharp drop in JGB prices could significantly destabilise the financial sector, as most government bonds are held by domestic banks.

The BoJ will inevitably become more entwined in the government’s debt management as it aggressively expands its JGB buying with the aim of defeating deflation. As a result, the BoJ may find itself needing to prioritise the stability of the government bond market (and the financial system) over price stability. In other words, even if warranted for price stability, rate hikes and the sale of JGB holdings could be held back. In order to avoid this, it is vital that aggressive monetary easing be undertaken together with a credible fiscal restructuring plan.

Implications of buying longer-dated JGBs
The Shirakawa-led BoJ steadfastly held its JGB purchases to those with maturities of less than three years, as it thought this would dispel suspicions of monetisation (but maybe avoiding monetisation and avoiding deflation are antithetic). Under that policy, the retirement of maturing bonds would shrink the BoJ’s JGB holdings to a normal level in three years, without a having to engage in any selling operations. The new Kuroda-led BoJ is bent on buying longer-dated JGBs. This could intensify the dilemma of having to choose between price stability or financial-system stability when inflation actually starts to pick up. Moreover, at that juncture, fiscal policy may be calling the tune and the BoJ may be obliged to respond as conditions warrant.

BoJ too late to the inflation-setting party?
It is ironic that the BoJ was forced to adopt an inflation targeting regime at a time when other central banks are re-examining its usefulness. Until the global financial crisis, monetary policy in most advanced countries was centred on price stability, as it was felt that that would create the foundation for stable and sustainable economic growth. But now, with the responsibility for preserving financial-system stability, the role of central banks as lender of last resort, market maker of last resort and guardian of fiscal stability has grown in importance. Central banks are now having to reconsider their objectives and priorities. It is in this setting that the usefulness of inflation targeting is being questioned, with Harvard’s Jeffrey Frankel going so far as to write its obituary last May (The Death of Inflation Targeting).

A pronounced inclination towards monetisation
Democratic governments in low-growth economies sometimes rely on their central banks to support fiscal policy so as to avoid asking voters to share more of the burden. It is the pathology of modern democracies to foist our bills onto future generations and one could argue that the prolongation of our zero-rate regimes and quantitative easing are facilitating this. When this societal weakness is combined with today’s financialised economies, we get a pronounced inclination toward monetisation, which could lead to very serious problems. While Governor Shirakawa has described the BoJ as the “frontrunner” in venturing into unknown territory with policies like zero rates and quantitative easing, Japan could also become the frontrunner of outright monetisation.