Just don’t mention the yen

Today’s “Comprehensive Assessment” by the Bank of Japan of its stimulus efforts has in our view underemphasised the role of the weaker yen in bringing Japan out of deflation. The data show a very strong link between lagged moves in USD/JPY and Japan’s core inflation rate, Exhibit 1. Moves in the yen over the last year indicate that Japan’s core CPI may once again be falling back towards zero which may induce the BOJ to engage in further stimulus efforts. However, we wonder if the lower bound on interest rates is not the only constraint central banks are now facing.

The implementation of QE-extreme in Japan has led to the central bank becoming the owner of 41% of Japan’s government bond market, a top-ten holder in 90% of Japanese equities and have a balance sheet worth 90% of Japan’s GDP. In the BOJ’s Comprehensive Assessment published earlier today the central bank confirmed its belief in the effectiveness of its policies, in closing the output gap and bringing Japan out of deflation.

The BOJ stated that it had examined how the intended mechanism of QQE has actually worked. The primary mechanisms were supposed to be changing Japan’s deflationary mindset by signalling the Bank’s determination to reach a 2% inflation target and putting downward pressure on the yield curve.

Depreciation of the exchange rate and the portfolio balance channels (i.e. higher equity prices) were second last and last in the list of intended mechanisms. Furthermore, it was even suggested that the decline in the exchange rate might not even be considered part of QQE.

The BOJ also attributed the recent rise in core CPI inflation to its stimulus efforts. However the shortfall in inflation versus the 2% target was blamed on external factors such as the decline in the oil price and the weakening of emerging markets, rather than any potential lack of efficacy of the BOJ’s policy.

It is in our view however astonishing that there was no detailed discussion on the seemingly close relationship between the value of the yen and Japan’s core inflation rate. A simple regression is highly suggestive of a 12m-lagged relationship between Japan’s core CPI and the USD/JPY exchange rate, as shown in Exhibit 1.

Exhibit 1: Lagged USDJPY and Japan’s core inflation rate

We can understand that central banks are highly sensitive to accusations of currency manipulation or policies which target the exchange rate, and this sensitivity may also impede open debate. Unfortunately, the absence of a discussion leaves open the possibility, as Exhibit 1 shows, that if the relationship of the last 10 years still holds, the recent strength of the yen is likely to act as a significant drag on Japanese inflation for the next 6m. In this context, it is no surprise that the BOJ has had to add another two dimensions to its monetary easing efforts – “yield curve control” and “inflation overshooting”.

While global markets in the short-term are likely to be supported by the belief that the BOJ remains firmly on an easing track it is in our view becoming increasingly clear that Japan’s extreme monetary policy has been and remains highly reliant on currency devaluation to achieve its inflation objective. In this regard, the strength of the yen today, immediately after the BOJ’s new “yield control” and “inflation overshooting” policies will be of concern to Japan’s policymakers.

Much is spoken of the zero lower bound for interest rates but fewer central bank policymakers seem willing to admit that after many years of unconventional monetary policy experiments across the globe, there are other, growing, constraints. The damage to liquidity in bond markets and creeping nationalisation of stock markets hints at limits to action further out on the yield and risk curve.

Furthermore, the growth of popular political movements, including those in Europe and the US, at least in part reflect the sense of unease in respect of the weaknesses inherent in an economic stimulus dominated by monetary policy. In a similar manner to other central banks, it cannot be ruled out that the BOJ is being forced to pretend and extend policies which, had they been as effective as anticipated, would now be in the process of being wound down.

In terms of the global picture, at current extended bond and equity valuations, investors continue to price in a long period of continuation of current monetary policies. We believe investors should exercise more caution; a more expansionary role for fiscal policy, likely in the UK and possible in the US during 2017, could lead to a very different return expectations for both bonds and equities.