Japan Watch – Mission accomplished?

by: Bill Diviney

  • It has taken enormous monetary firepower, but the authorities appear – finally – to be winning the battle against deflation
  • Modestly above-trend growth has helped close the output gap, and productivity growth is outperforming other advanced economies
  • The tight labour market is finally lifting wage growth, and inflation is following – with a lag
  • We expect the BoJ to continue its ‘stealth’ normalisation of monetary policy, with a close eye on the yen exchange rate
  • We look for the yen to strengthen to 100 vs the USD by end-2019
180820-Japan-Watch.pdf (193 KB)

Abenomics is finally paying off

After more than five years of historically unprecedented monetary easing, Japan’s economy is finally emerging from decades of deflation. While there remains considerable progress to be made, ‘Abenomics’ and the Bank of Japan’s Quantitative and Qualitative Easing (QQE) policy have helped close Japan’s output gap, generating some limited inflationary pressure. With the economy broadly on the right track – even if the BoJ’s 2% target is still some way off – the central bank has become confident enough to take baby-steps towards normalisation, and to reduce some of the more negative side effects of its extraordinary policy stance.


Growth has been unspectacular, but nonetheless above potential

Growing at an average annualised pace of 1.4% qoq since the advent of Abenomics in 2013, Japan’s economic performance has hardly been spectacular. However, such a low figure is still above Japan’s subdued potential growth rate of c.1.0% (which is low chiefly because of the declining population). As a result, slack has been absorbed, and the output gap is now estimated by the Bank of Japan to have been +1.7pp above potential as of Q1 18 – the most since Q1 2008, and 3.1pp above where it was in pre-Abenomics 2012.

Contrary to conventional expectations at the time of Abenomics’ introduction – and despite the dramatic fall in the yen – this boost to growth was not driven chiefly by goods exports. While goods export growth has indeed picked up, a bigger impetus to growth has come from investment, and an unexpected tourism boom. Almost half of the 6.5% growth from 2012-17 has come from investment (+3.1pp), while another 0.7pp has come from net services exports, around 90% of which coming from the travel segment; in contrast, net goods exports contributed just 0.3pp over this period. Visitor arrivals to Japan have more than tripled to over 30mn over the past 12 months, from 8.7mn at the pre-crisis peak in 2007. The rise has been fuelled in part by the weak yen, but also by the rise of the Asian middle class, with mainland Chinese tourists growing at double digit rates. As well as contributing to GDP growth, the tourism boom has also driven a sharp improvement in the services deficit, with the travel balance moving from a persistent deficit to a surplus.


Investment appears to have lifted productivity growth

The strong investment growth in recent years, coupled with an exceptionally tight labour market, also appears to have driven a pickup in productivity growth. According to OECD data, productivity growth accelerated to 1.0% from 2012-2016, up from 0.6% in 2010-12, and outperforming the US (0.4%) and the OECD as a whole (0.8%) over the same period. Indeed, faced with labour shortages, it appears that companies have – at least until recently – preferred to invest in labour-saving technology rather than to raise wages to compete for labour.


But above-potential growth cannot be sustained for much longer

But with the output gap already positive, how sustainable is above-potential growth? Not very, in our view. After a strong 2017, growth has already slowed into 2018, with GDP falling -0.9% qoq annualised in Q1, driven by weak private consumption and a downturn in residential investment following a period of relative strength in the housing market. GDP rebounded in Q2 by 1.9% qoq annualised, on the back of a strong recovery in private consumption, but this pace is unlikely to be sustained. First, as discussed below, the labour market is exceptionally tight, and the main source of growth from hereon is likely to be from productivity and real wage growth rather than employment gains. Second, global trade is facing increasing headwinds from protectionism, and China’s economy also looks to be slowing in the second half. This should partly offset some of the tailwinds from somewhat stronger US and eurozone growth. Finally, part of the strength in investment we have seen is a result of preparations for the 2020 Tokyo Olympics. As this spending starts to slow, investment growth is likely to cool significantly – although we expect the impact of this to be more apparent in the second half of 2019. This will also coincide with the consumption tax hike, although we expect the impact from this to be much smaller than the previous hike, given that the relative change in the tax rate is much smaller (from 8 to 10%, compared with from 5 to 8% the last time around), and with the economy on a stronger footing. All told, we expect growth roughly in line with potential for this year and next, at 1.0%.

Stronger wage growth is helping the BoJ towards its target

While it has taken years of ultra-loose monetary policy, wage growth is finally picking up, driven by exceptional tightness in the labour market. The unemployment rate is near a 25-year low at 2.5%, while the vacancy to applicant ratio is the highest since 1974, at 1.62. The tightness in the labour market likely helped average monthly cash earnings (including bonuses) surge by 3.6% yoy in June, the fastest pace in over two decades. In the year to date, wage growth has averaged 1.8% yoy, significantly up on 2016-17’s 0.5%. Stripping out bonuses, wage growth is more subdued at 1.1% year-to-date, but this too is the highest it has been in over 20 years. In short, there has been an unmistakable shift in wage-setting behaviour over the past year.



CPI inflation excluding fresh food and energy has picked up to 0.3% yoy, continuing to lag wage growth for the time being. However, the trend has turned upward, and we expect businesses ultimately to pass on higher wage costs in the form of price rises. In the meantime, historically elevated cash balances could slow that pass-through. All told, we expect core inflation (ex-fresh food & energy) to pick up to 1.7% yoy by the end of 2019, or 1.2% excluding the effects of the planned consumption tax hike in October 2019. This will add approximately 50bp to core inflation, much less than the almost 2pp that the previous tax hike added.

While we still see the BoJ’s inflation projections as rather optimistic , the gap with realised outturns is likely to narrow, and given the significant strengthening in wage growth, the 2% target now looks much more achievable than it had previously. This has likely been what has given the central bank greater confidence to take small steps back from ultra-loose policy, and to reduce some of the side effects – namely on bank profitability.

BoJ View: Gradual ‘stealth’ normalisation to continue

The Bank of Japan made important changes to its policy framework at its 31 July policy meeting. The biggest was to increase the flexibility of its Yield Curve Control (YCC) policy, by allowing the 10y JGB yield to trade in a wider range. BoJ governor Kuroda stated that he saw a ‘doubling’ in the trading range from +/-0.1% (i.e. to +/-0.2%), although this was not specified in formal written communications – and we believe it was left deliberately ambiguous. In addition to this, the BoJ added new forward guidance on interest rates, stating that rates would be kept ‘extremely low’ for an ‘extended period’, with explicit reference to the planned consumption tax hike of October 2019 (and the need to assess the potentially negative effects of this) as an anchor point. This sent a very strong signal to markets that further formal changes in policy before 2020 are unlikely.

Viewed in isolation, the change to the YCC framework could arguably be viewed as a tightening step for the BoJ. Indeed, while the target for the 10y JGB yield is still ‘around zero’, the cap is now at 0.2%, up from 0.1% previously. However, the move was communicated as making loose policy more sustainable over a longer time frame, coming as it did alongside downgrades to the BoJ’s inflation forecasts. While inflation is moving in the right direction, it will ‘take more time than expected’ for the BoJ to reach its 2% target. The BoJ had come under significant pressure from financial institutions struggling with the combination of negative short rates and an exceptionally flat yield curve. While Governor Kuroda stated that it is not his job to improve the profitability of banks, he did nonetheless point to the risks to market functioning and financial intermediation from BoJ policy. The changes to policy are relatively small, but they should help to alleviate some of the pressures on bank profitability, while also fostering more normal market conditions for Japanese government bonds (liquidity has become scarce, and since the introduction of YCC in 2016, there have even been days when not a single JGB was traded).


Stealth yield cap rises are likely to accompany the stealth taper

Meanwhile, the Bank’s ‘stealth taper’ has continued. While the BoJ officially still has a quantitative target to expand the monetary base at ‘around’ JPY80trn per year, the pace of purchases has been on a clear downtrend, and over the past 12 months the monetary base expanded by just JPY41trn. At some point, the BoJ ought to officially drop this target (particularly given that its main policy target has become the yield curve), though our base case is that this will not happen until January 2020. By this time, we should have enough data to assess whether the economy has reacted overly negatively to the consumption tax hike.

The communication on the yield curve target appears to have been left deliberately vague at the July policy meeting, in our view reflecting the disagreement on the committee over how much the 10y yield should be allowed to move. We think something similar to the stealth taper is ultimately likely to happen, whereby the 10y JGB yield is allowed to move above the implicit cap of 0.2%. Ultimately, we think the ‘hard hard’ ceiling on yields before a formal policy change would be 0.5%. Below this, it could still – at a stretch – be argued that the BoJ is hitting its target of ‘around zero’. Consistent with this, we have raised our JGB 10y yield forecasts to 0.10% for end-2018 (previously 0.0%), and to 0.30% for end-2019 (previously 0.20%).

All of this of course hinges on economic and market conditions, and in particular whether the USD/JPY exchange rate moves significantly lower. Despite Japan’s reduced reliance on goods exports as a growth driver, the link between business confidence and the exchange rate is historically entrenched, and as such it will remain a key focus of policymakers in Japan. The 107 level is important, as it is the average rate predicted by large manufacturers in the Q2 2018 Tankan survey. However, we think USD/JPY would have to fall below 100 for the BoJ to shift from the normalisation path that it is currently on.