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The surprise decision by the Bank of Japan (BOJ) last Thursday to leave policies essentially unchanged while downgrading the growth and inflation forecasts has unnerved markets. The Nikkei index has tumbled more than 5 percent, the yen has appreciated, and 10-year bond yields moved further into negative territory. Investors appear to be anticipating lower inflation and growth. This comes after a similar negative reaction to January’s decision to inch policy rates below zero, which was seen as too little to fundamentally alter the trajectory of the economy.
Markets needed a surprise, but this one was in the wrong direction. What is required is a bold initiative rather than renewed paralysis. Indeed, aggressive action is what Prime Minister Shinzo Abe promised when he was elected more than three years ago. His “Abenomics” replaced the existing policy drift, which had left the economy moribund for well over a decade, with a new energy in which monetary, fiscal, and structural policies would combine to revive the Japanese economy.
"Markets needed a surprise, but this one was in the wrong direction."
Under the BOJ’s new governor, Haruhiko Kuroda, monetary policy was at the forefront of this new, more vigorous approach. Governor Kuroda promised to raise inflation to the new target of 2 percent per year “at the earliest possible time, with a time horizon of about two years.” He combined these words with a new program of quantitative easing, purchasing massive amounts of long-term bonds and small amounts of equities and real estate. And these policies worked. Deflation of nearly 1 percent per year was replaced by inflation of just over 1 percent in terms of core consumer prices.1 However, core inflation stopped rising six months ago, well short of the central bank’s 2 percent goal. More worrying is that measures of inflation expectations in bond markets, which rose dramatically after Prime Minister Abe’s election, have now dropped back almost to pre-Abe levels.
"What is required is a bold initiative rather than renewed paralysis."
The risk is that the Japanese economy gradually sinks back into the pre-Abenomics trends. Nominal GDP in 2012 was lower than it had been 20 years earlier, reflecting decades of deflation and slow growth in real output. Stagnant nominal output and continuing fiscal deficits drove up the ratio of government debt compared with the size of the economy. Japan needs steady growth and inflation of at least 2 percent to put its national debt on a stable trajectory.
Strong, decisive policy action is needed—and soon—to convince markets the BOJ is still determined to achieve 2 percent inflation. With 10-year government bond yields now below zero, the most effective option is to ramp up purchases of other assets. Currently, the BOJ is buying about 0.5 percent of outstanding equities per year. Raising the rate of purchase to 10 percent would herald a major break with the past, pushing up equity prices and encouraging consumption and investment through higher household wealth and lower cost of capital.
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1. This statement is based on consumer prices excluding fresh food and energy. See the BOJ’s Outlook for Economic Activity and Prices, April 2016.
