The JGB market was completely unfazed by the news that the prime minister’s office was reconsidering the planned consumption tax hike. While the tax hike is unlikely to be changed; in BNP's view, the market’s lack of response to tail risk looks like proof that its function has been impaired by the BoJ’s massive buying. Even if the Abe regime is opting for financial repression to reduce the public debt, however, BNP warns that some degree of fiscal reform is needed to control the long-term interest rate. If the unfazed market is deemed to mean that fiscal reforms can be shelved without fear of a bond-yield spike as long as massive BoJ buying continues, serious problems could ensue.
The JGB market was entirely unfazed by the news that the prime minister’s office was mulling a change in the timing and/or scale of the consumption tax hike (5% to 8%) slated for next April. To some, this lack of response reflects a dispassionate assessment of market participants that, despite all the talk about possible changes, the sales tax hike cannot be easily undone, having been enshrined in law. As the legislative process would have to start over to change it, we concur that it would be very difficult to devise a new plan. Still, just because the base-line scenario of most market players holds that the consumption tax hike will be implemented as planned, it does not follow that the probability distribution of the hike should be the same as it was. If rising tail risk is priced in, the long-term interest rate should pick up to some degree.
In our opinion, the JGB market has become unable to price in risk, because the Kuroda-led BoJ’s aggressive purchasing has greatly impaired the market’s function. Normally, the yield curve prices in factors such as inflation expectations, economic growth forecasts, the likely future path of overnight rates, fiscal risk premiums, etc. By discounting future changes in these economic fundamentals, financial markets perform the proper role of price discovery. However, owing to the BoJ’s overwhelming bond purchases, transactions among other market participants have essentially dried up. With the BoJ being party to most transactions, bond prices no longer reflect news on Japan’s economic fundamentals.
Questions, however, remain as to whether it is even possible for Japan to generate inflationary expectations. The traditional mechanism for transmitting monetary policy – rate cuts that stimulate demand, thereby causing improvements in the output gap, which stoke inflation – is currently not an option in Japan, as both the short-term and long-term interest rates are essentially at the zero bound. While the reflationists surrounding Prime Minister Shinzo Abe argue that inflationary expectations can be fostered by expanding the money supply, the theoretical rationale for this quantitative easing is the quantity theory of money, which does not hold when the nominal interest rate is zero.
Incidentally, theories on how the price level is determined fall into two broad categories, the quantity theory of money and the fiscal theory of the price level (FTPL). While the former holds that monetary policy determines the price level, the latter makes fiscal policy the main determinant. When the central bank succumbs to fiscal dominance, wherein monetary policy is dictated by fiscal affairs and not the economy and prices, the applicable model is the FTPL.
Under the FTPL model, fiscal policy can fall into two regimes:
(1) Ricardian, whereby governments demonstrate fiscal discipline by indicating that the public debt will be repaid with future tax increases, and
(2) non-Ricardian, whereby governments aim to settle the national debt via inflation, not tax increases. In the case of non-Ricardian fiscal regimes, the government relies on financing from the central bank to retire government bonds, so monetary policy is effectively called on to clean up after the government.
What happens if we apply this model to Japan? For starters, the absence of positive price growth is not because of insufficient monetary easing, but the widely held view that the government will ultimately come through on fiscal restructuring, including tax hikes. In other words, past Japanese governments were deemed to have Ricardian fiscal regimes, hence the lack of inflation.
But policy seems to have taken a non-Ricardian turn since the Abe administration took office.
First, the government has pressured the BoJ into adopting more aggressive easing, while also swiftly enacting an aggressive package of fiscal spending worth 2% of GDP. Together, it seems that the BoJ is financing the government’s spending spree (monetisation).
Second, the prime minister’s office is now wavering on the consumption tax hike. While this might just be a ploy to squeeze more spending from the hawkish MoF, all of the aforementioned actions could be construed as non-Ricardian. Even if the 2% inflation target in two years proves unattainable, the FTPL model suggests the probability of defeating deflation have greatly increased.
The thing that worries us most is how those surrounding the prime minister will react to a JGB market that does not price risk.
Matters could get very serious if they believe
(a) that the fiscal hawks were wrong about scrapping the sales-tax hike, triggering a fiscal crisis via a spike in bond yields, or
(b) that fiscal restructuring can be put off without provoking a spike in bond yields as long as the BoJ continues to aggressively buy long-term JGBs.
Even if the authorities are deliberately opting for financial repression to steadily inflate away the public debt by fostering negative real interest rates, some degree of fiscal restructuring is still needed to ensure stable control over the long-term interest rate.
Relying on seigniorage alone to repay the public debt could ultimately lead to double-digit inflation that would be socially unacceptable. Then again, surging term interest rates could make it impossible to rely on seigniorage. There is a good chance that financial repression will not succeed unless it is part of a package that includes credible fiscal restructuring comprising spending cuts and tax increases.