Inflation target within time frame a challenge
There are signs that there is actually now more spare capacity in the economy, which is a negative for inflation. The output gap was positive during December 2013 to May 2014 but it has since turned negative.
In addition, inflation excluding the effects of volatile items such as food and energy as well as the sales tax is only modestly positive. As such we have doubts that economic growth will be strong enough to push core inflation (the official measure is excluding food but including energy) will reach 2% over the next year excluding the sales tax effect. Further monetary easing to bring down the yen and ease financial conditions more widely will be necessary to keep inflation on track to meet its goal.
Options that the BoJ have
We think that there are 4 options the BoJ could take. First, the central bank could acknowledge that the 2 year time frame is too ambitious. Second, the 2% inflation target could be lowered. Third, they could follow the ECB’s route of negative deposit rates. Lastly, they could extend their qualitative and quantitative easing (QQE) programme in 2015 to achieve their 2% inflation target within a 2 year time frame. In our view, the latter is more likely as explained below.
Stakes are high…credibility at stake
There has been market speculation that the BoJ could accept that inflation will simply take longer to reach its target or accept a lower inflation goal. It is further argued that given that deflationary pressures have reversed and inflation expectations are on an uptrend from a longer term perspective, further monetary easing may therefore not be necessary. We think that this is unlikely as it would trigger doubts about the BoJ’s credibility to inflate the economy and the success of Abenomics. Inflation expectations are likely to decline, which could result in companies and households delaying spending. Indeed, the market is already challenging the BoJ’s view that it will be successful in achieving its 2% inflation on a sustainable basis.
We think this is partly due to the failure of Kuroda’s predecessors to deliver on similar promises. Kuroda has also previously stated that the premature ending of quantitative easing in 2006 has made it hard for the BoJ to gain credibility as a deflation fighter. In short, we think the stakes are too high for the BoJ to drop its 2 year time frame for the inflation target.
Negative deposit rates?
The BoJ’s large liquidity injections into the banking system have resulted in short term bill yields moving into negative territory. Should the BoJ follow the ECB’s example and cut its deposit rate in order to push the short end of the curve more significantly into negative territory?
According to IMF study in 2003, a 100bp cut in short term rates was estimated to raise Japan’s GDP by around 0.5% with a lag (using data from 1991-2002). As such the impact might be minimal unless the BoJ were to move deposit rates into very deep negative territory. One reason to doubt the usefulness of a rate cut is the structure of household balance sheets in Japan. Households have a relatively large assets in time deposits relative to equities (historically more than four times). As such it is likely that the negative income effect offsets or even outweighs the positive wealth effect from higher equities.
Nevertheless, the negative income effect should not be exaggerated due to households’ portfolio rebalancing. The increase in households’ equity holdings has outpaced deposit holdings by more than five times in the past year as both the government and central bank took measures to reflate the economy.
It is also important to note that since the BoJ implemented QQE in April 2013, financial institutions reserves with the BoJ have almost tripled to more than 161 trln JPY as of September 2014. Domestic banks surplus liquidity (deposits minus loans) have also increased by more than 16 trln JPY. Imposing a charge on reserves parked with the BoJ is likely to encourage more lending to stimulate the economy. Reducing real interest rates further will also help to stimulate the housing market and business investment, which produces the economic cycle of higher profits and wages and results in consumption growth. Hence, there are still merits for Japan to lower deposit rates further (10-20bp) into negative territory though other less unconventional measures are likely to be implemented first to stimulate the economy.
Extension of current QQE programme
We think that the BoJ is likely to target an even more aggressive expansion of its monetary base in 2015. The majority of monetary stimulus is likely to be focused on Japanese government bonds (JGBs). As the average maturity of JGB issuance for FY 14 is 8-9 years, we think there is some scope for the BoJ to increase the maturity of its holdings from current average 7 years. Consequently banks’ interest rate risk on JGBs should decrease as banks reduce longer maturities JGBs. This will allow more risk taking capacity and result in an increase in bank lending. Given constraints in the market size of J-REITs, increases in ETF, CP and corporate bonds purchases are also more likely. Other credit enhancing measures are also likely to stimulate lending activities. The BoJ is unlikely to increase the pace of its monthly JGB purchases substantially to avoid market concern that it is financing the fiscal deficit.
Liquidity issue in the JGB market?
It is also sometimes argued that the BoJ’s aggressive expansion of its balance sheet has sparked concerns that liquidity in the JGB market is drying up as the central bank becomes a dominant player. Indeed since April 2013 the central bank’s balance sheet has risen from 20% of outstanding government bonds to slightly above 30%. Nevertheless, an extra supply of JGBs worth 17 trln JPY could flow into the market if the Government Pension Investment Fund (GPIF) reduces its weighting for JGBs from 53.36% (as of end June 2014) to around 40%. It is also worth noting that Japan Post which holds about 60% of total assets in JGBs (worth more than 170 trln JPY and 2.5 times of GPIF JGB holdings as of June 2014) could follow suit in the future. The supply could also be amplified if other insurers reduce their allocation in local JGBs in favour of higher yielding foreign bonds.
Timing of upmost importance
We think that in the next monetary policy review on 31 October, the BoJ could signal that more stimulus measures will be announced after preliminary third quarter GDP is released in the middle of November and/or when the government announce their decision (by the end of 2014) to raise the sales tax as planned. BoJ governor Kuroda has also acknowledged that there are no limits to what additional steps they can take and that the positive impact on the economy will be magnified if it is not fully anticipated by the market. Indeed according to a Bloomberg poll conducted from 26 September to 2 October, less than 25% of economists expect the BoJ to embark on more easing measures in 2014 with slightly more than 40% of those surveyed expecting the BoJ to wait till early next year while 33% do not expect more actions.
Implications for the Japanese yen
We expect the yen to decline to 115 by the end of this year. The consensus is that the BoJ will implement more stimulus only in early 2015. Hence the surprise element of BoJ moving will exert further downward pressure on the yen. Furthermore the market is significantly under estimating the pace of rate hikes in the US next year. We think that further adjustment in short term yields in the US will materialise in the coming months. As interest rate differentials between US and Japan widen, the US dollar is expected to continue its outperformance against the yen. We expect the JPY to decline to 125 against the USD in 2015.
In addition, we think that outward investments in foreign bonds are likely to accelerate as investors seek higher returns while investments in foreign stocks may decline as domestic equities are preferred. Overall outward investments will remain positive and this will continue to weigh on the JPY. Having said that, the negative impact on the JPY is likely to be less pronounced than the first quantitative and qualitative easing measures announced last year due to diminishing law of returns. Furthermore speculative short positions in the JPY are also increasingly overcrowded.