Bank of Japan: Key Takeaways from New Japanese Monetary Policy

The two major announcements during the week were the monetary policy announcement by the Bank of Japan as well as the outcome of the US Fed meeting. While there is a consensus that the Fed will choose to maintain status quo on rates, the Bank of Japan’s stance on interest rates and liquidity was of greater interest to most analysts.…

Highlights of the monetary policy announcement by Bank of Japan (BOJ)…

  • Japan has retained its benchmark interest rate at (-0.1%) after sliding into negative rates earlier in the year
  • The Bank of Japan continues to target 2% inflation and the liquidity infusion is designed to create demand-pull inflation in the economy
  • The Bank of Japan will continue its Bond Purchase Program at the rate of $787 billion per year to infuse sufficient liquidity into the system
  • Bank of Japan has promised to keep benchmark yields on 10-year Japanese bonds at around the 0% mark.

The Japanese economy is currently going through 3 major economic contradictions. Firstly, despite the substantial infusion of liquidity and low rates, there has hardly been any pick-up in economic growth. On the contrary, banks are losing out due to negative rates on their reserve money. Secondly, despite a surfeit of liquidity in the system, inflation continues to be elusive, which is more because the low inflation is driven by supply-side factors like cheap oil and commodities. Lastly, the Japanese Yen, which was supposed to weaken due to the liquidity infusion, has actually ended up strengthening against the dollar. Let us look at each of these contradictions and its implications for Asia in general and India in particular.

Contradiction 1: Low economic growth despite liquidity and low rates…

Back in 2012, when the idea of infusing liquidity to boost growth was first mooted by Shinzo Abe, it created a runaway rally in the Nikkei. However, over the last couple of years, Abenomics has failed to deliver in terms of any meaningful improvement in economic growth. Japan continues to show flat to negative growth in most quarters. The logic was that low rates and a surfeit of liquidity will leave banks with little incentive to park their money in bonds. This will induce banks to lend money to industry, which will be only too happy to borrow at near-zero rates. What actually happened was exactly the opposite. There was hardly any demand for credit from industry due to weak growth prospects and limited investment opportunities. There was an expansion in retail credit and this only spurred asset inflation making already expensive assets almost exorbitant.

What this means for Asia and India is that Japan is likely to continue its easy money policy and that will largely limit the ability of the US Fed to be too hawkish.

Contradiction 2: Low inflation despite massive liquidity and low rates…

This experience has been visible across the US, Europe and Japan. Despite infusion of liquidity and low rates, there has been no urge to splurge. Retail spending is hardly picking up in any of the economies and Japan has been no exception. As a result, inflation continues to remain below the 1% mark. This is more so because the low inflation is driven by supply side economics. Weak global oil prices and tepid commodity prices mean that any liquidity infusion or rate will have little impact on pushing up inflation. The main factor is supply-push and not demand-pull.

For other Asian economies and India it means two things in particular. Firstly, with supply side continuing to put pressure on oil and commodities, central banks will continue to infuse liquidity in the system in an attempt to prop up inflation. Secondly, Japan and India are net importers of oil and commodities and hence benefit substantially from low prices. The inflation stickiness in Japan indicates that the dividends of cheap commodities are likely to continue.

Contradiction 3: Strong Yen despite liquidity and negative rates…

This contradiction has become a real problem for Japan. But why has the Yen strengthened? Japan runs a current account surplus and therefore the natural expectation is for the Yen to appreciate in a secular manner. Even with negative rates, investors are betting that the appreciating Yen will result in decent gains in currency neutral terms. That is what is spurring the demand for Japanese bonds and making the Yen stronger versus the Dollar. A strong Yen is not great news for Japan as its strategy of exporting its way out of the economic slump is not yielding fruit.

For Asia and the Indian economy, this is good news as a strong Yen keeps the dollar in check. With a $22 billion pay out on account of the FCNR (B) redemptions, India would be keen to see a strong Yen keep the USD in check.

The latest monetary policy announcement by the BOJ highlights that the Japanese economy and the central bank may actually be running out of options. For the Japanese economy, the time may have come to shift from pure monetary stimulus to fiscal stimulus. The government, perhaps, needs to spend its way out of a slump rather than just infusing liquidity. That is more likely to work!
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