Japan Watch – BoJ to delay monetary easing

by: Maritza Cabezas , Roy Teo

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  • Despite ongoing subdued inflation, the BoJ will likely postpone stepping up stimulus to early 2016 from our initial view of July 2015. For now, there are concerns that the fast pace of depreciation in the yen could lead households to cut down their spending as a result of the higher import costs. On top of this, in April, the BoJ delayed the timing of reaching the price stability target of 2% from 2015 to around the first half of fiscal year 2016. This and a more optimistic view from authorities on the Japanese economy, suggest that a new round of easing is unlikely this year.
  • However we judge that there will be further monetary stimulus early next year as we expect inflation to undershoot the BoJ’s forecast. We expect inflation to rise to around 1% in 2016. By early 2016, the pressure for the BoJ to maintain its inflation credibility will increase. The impact of higher import cost due to the weak yen will fade as the pace of yen depreciation against its trade weighted basket of currencies slows.  We expect the yen to decline relative to the US dollar to 128 by the end of this year and 135 in 2016.

A delay in easing… change  of BoJ communication

We no longer expect the BoJ to step up its asset purchases in July 2015, as several developments suggest it will be delayed. To begin with, in April 2015, the BoJ pushed forward the price stability target of 2% from 2015 to around the first half of 2016, mainly as a result of the lower oil prices and the impact on inflation. The communication around the inflation target has also been changing. The price stability target is now seen as a flexible concept with a certain range for upward and downward deviations of the actual inflation rate. This approach gives more flexibility for authorities to see how the “Abenomics” strategy plays out as well as the outcome of wage negotiations, before adding more stimulus. At the same time, the Bank’s Policy Board has signalled that the underlying trend in inflation would be firmly maintained under the virtuous cycle of the economy.

…as well as a too fast pace of yen depreciation…

On top of this, Mr. Kuroda in his latest verbal intervention has expressed concern about the yen’s pace of depreciation and the negative impact on the economy. Indeed, the undesired pressures of a weaker currency on imported inflation for consumers is a strong reason for a more cautious approach when it comes to easing, given the recent setback in consumption resulting from the VAT hike.

… while economy showing signs of recovery

In the first quarter the economy performed better than expected. Real GDP grew by 3.9% up from 1.2%. The main drivers were private capital investment and inventories.  Stronger capital investment is likely going forward, since corporate balance sheets will remain strong. Corporate profits in the last two quarters of 2014 were at record highs. Profits have been partly buoyed by lower raw material costs as a result of the drop in crude oil prices and higher overseas sales resulting from the weaker yen. These conditions should continue.

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On top of this, the 2015 wage negotiations agreement is likely to result in a base wage increase of 0.6-0.7%, which is higher than 0.4% increase in 2014. This is a modest increase should provide more confidence to consumers to increase their spending.

More easing needed …BoJ to maintain inflation credibility Though market measures of inflation expectations have been slowly increasing so far this year, consistent with a turnaround in global inflation expectations, they remain below the price stability target of 2%. We expect inflation to rise to around 1% in 2016, but remain well-below the goal. By early 2016, the pressure for the BoJ to maintain their credibility in achieving their 2% inflation target will build.

… concerns of yen depreciation to fade

The BoJ does not have an exchange rate target but an inflation mandate. We judge that concerns about a weak yen will dissipate. Nominal wages are expected to rise  and this will mitigate concerns of higher imported inflation. By early 2016, a gradual improvement in economic growth and inflation outlook will also support domestic consumption. Furthermore, we expect the pace of yen depreciation to slow in 2016 as financial markets anticipate that a tapering of central bank asset purchases could begin the following year.

Medium-term sustainable growth outlook still a concern

Looking ahead, the sustainability of economic growth in 2016 and thereafter remains a concern. Indeed, reforms are taking time to implement and results are only slowly being delivered. We even sense that there is a “reform fatigue” as the approval ratings of the Prime Minister have reached their lowest levels since taking office. This will likely lead the administration to proceed with caution on controversial reforms, including the labour market, possibly impacting the view on economic growth. The government’s predictions, however, for productivity growth remain optimistic. It expects that between 2016 and 2020, productivity growth, the efficiency with which capital and labour are used, to increase from 1% to 2.2%. The pace of increase of firm’s productivity will be the basis for wage growth. The recovery in wages is essential to boost in inflation, resulting from stronger domestic demand.

Ambitious growth forecasts, a risk to fiscal sustainability

The implications of this positive growth scenario are large. Indeed, the Council on Economic and Fiscal Policy has  included an ambitious nominal growth assumption of 3-4% in the next five years and a fiscal deficit of 1.6% of GDP in FY 2020. Under this optimistic assumption the government expects a flood of tax revenues to alleviate the need for big cuts to spending or large tax increases. The government has at the same time set a new 1% of GDP interim deficit target for FY 2018, down from 2.1%. If the government misses this target, we think that the credibility of the fiscal strategy will be at risk and this is critical for long-term growth prospects.

Remain bearish on yen; forecasts unchanged

Despite delaying our call on the timing of BoJ stimulus from July this year to early 2016, we have left our 2015 year end USD/JPY forecast of 128 unchanged. This reflects that outward investment from Japan has been stronger than expected. Japan’s total portfolio investment abroad in the first 4 months of this year totalled more than JPY 11.9 trillion, 7 times larger than the historical average from 2005 to 2014. Second, there is some evidence that the currency hedge ratio of overseas investments has declined. Third, speculative short futures positions in the JPY are not overcrowded.  Last but not least, financial markets are still underestimating the magnitude of rate hikes in the US in our view. Widening interest rate differentials between the US and Japan will lead to a higher USD/JPY.

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