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Marcuard's Market update by GaveKal Dragonomics
There is growing speculation that the Bank of Japan may follow the European Central Bank, which last week signalled additional easing, and the People’s Bank of China, which cut rates on Friday, and surprise the markets with further credit easing.
But while extra action from the BoJ could be a short term shot in the arm for the equity market (or not, given the underwhelming response to China’s easing), it is doubtful whether additional easing will further the cause of Japanese reflation, while any resulting yen weakness could do more harm than good.
In its board meeting on Friday, the BoJ is expected to downgrade the growth and inflation forecasts it issued in July to reflect the slowdown in emerging markets and continued low oil prices.
With headline inflation at just 0.2% in August, it could be argued that the central bank should do “whatever it takes” to hit its 2% inflation target. However, there are also reasons why the BoJ may prefer to stick with its current “quantitative and qualitative easing” programme. Most notably, headline and core — ex-food — inflation have been weighed down by lower fuel prices. On a seasonally-adjusted six-month annualised basis excluding the one-off effect of last year’s sales tax hike, “core core” inflation — ex-food and energy — is running at a decade high of 1.4%. So, with the oil price appearing to have found a bottom, the BoJ can reasonably point to Japan’s tightening labour market as a signal of a likely pick-up in inflation expectations.
The BoJ is also running up against the technical limits of its QQE programme. The central bank is already the largest holder of Japanese government bonds, with a 30% share of all outstanding issues. Facing the prospect of diminishing returns from further purchases, it is keen to conserve its ammunition to ensure that any additional action it is forced to take has the greatest possible impact.
As a result, in the absence of an exogenous shock, the BoJ is likely to be reluctant to expand QQE ahead of fiscal consolidation currently planned for April 2017, when a further consumption tax hike should be implemented.
What’s more, enthusiasm among government officials and business leaders for a further weakening of the yen has cooled lately after the last round of depreciation failed to boost export growth as much as hoped. The impact was muted in part because Japanese exporters chose to take advantage of the yen’s weakness to rebuild their profitability rather than to increase shipment volumes, and partly because Japanese manufacturers are more linked in to the global supply chain than before, with fewer of their costs denominated in yen and more of their production offshore.
As a result, the central bank’s policy of easing-induced currency depreciation has attracted criticism for exacerbating economic inequality by boosting exporters’ profits at the expense of domestic consumers, whose purchasing power has been reduced, which in turn has hit smaller companies’ earnings.
Having said that, Japanese exporters have changed their behaviour since the beginning of this year by starting to cut their prices. As a result, in contract currency terms Japan’s export prices have fallen -6% over the last 12 months (see the chart).
However, rather than boosting Japan’s market share, the price cut triggered currency depreciation across Asia, with the Korean won and Taiwanese dollar also weakening.
That shouldn’t have been too surprising, given that reflation policies have generally been a zero sum game. Their effect has been to redistribute nominal growth among economies rather than to boost overall aggregate demand. As a result, when one export-oriented economy devalues, the currencies of others also come under pressure, even if that means tighter financial conditions as the cost of servicing foreign currency liabilities rises.
In consequence, at this point additional easing leading to further yen depreciation could end up doing more harm than good. Although a stable yen implies a cyclical deceleration in exporters’ earnings growth, the easing policies pursued to date have helped overcome the entrenched deflationary mindset of Japanese corporations, encouraging them to invest more and increase compensation.
Meanwhile, structural reforms are gaining traction, holding out the prospect of margin expansion in domestically-orientated sectors. If the BoJ were to introduce more aggressive easing now, it would risk jeopardising this fragile equilibrium as additional yen weakness would further depress demand both at home and among Japan’s trading partners—a beggar thy neighbour effect which would eventually come back to haunt the Japanese economy.
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