September 11, 2013 5:35 pm

Three arrows and five rings: Abe’s inflationary quest

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Japan’s prime minister must tackle many adversaries before his quest is complete
©Reuters

Three magic arrows and now five interlocking rings. The more Shinzo Abe’s quest to breathe life into Japan’s economy goes on, the more it resembles something dreamt up by JRR Tolkien. Now he has sharpened two of his three economic arrows and grabbed the powerful Olympic rings, the Japanese prime minister is one step closer to slaying the Deflationary Dragon that has been terrorising the land for nigh on 15 years.

But not everything is happy in the Land of the Rising Sun. Deadly poison continues to spew from the northern lands of Fukushima. The ordinary folk do not yet feel prosperous, and they remain sceptical that Abenomics is anything more than a fleeting illusion. Former enemies across the sea, alarmed by what they regard as Japan’s lurch to the revisionist right, think of Mr Abe more as Sauron, the evil necromancer, than Gandalf, the benevolent wizard.

These difficulties aside, Mr Abe has had the prodigious luck enjoyed by the protagonists of many fantasy adventures. If it had not been for escalating tensions with China in the run-up to the election in December 2012, the leadership of the Liberal Democratic party – and hence Japan – would have almost certainly gone to a less hawkish politician. Then, as far back as November, before he was even elected, let alone before he put his economic plan into action, the markets began to move decisively in his favour. Stocks surged and the yen fell.

To cap it all, Mr Abe has secured the confidence-boosting Olympic Games for 2020. Amazingly, given Japan’s reputation as the sick man of Asia, it won because compared with Turkey and Spain it was judged rich and stable enough to take the event in its stride. Indeed, growth has risen briskly for three straight quarters, up by an annualised 3.8 per cent in the three months to June, putting Japan among the best-performing mature economies in the world. How the wheel has turned.

The place where much of this conjuring trick has been performed is the Bank of Japan, guardian of Mr Abe’s monetary policy arrow. Even officials at this institution, which for more than a decade denied its ability to manufacture inflation, privately admit to some surprise about how well things are going.

To recap: under Haruhiko Kuroda, the new governor, the BoJ has pledged to double the monetary base by massively stepping up its purchase of Japanese government bonds. It has committed to hitting a 2 per cent inflation target in two years. But quite how all this liquidity is meant to seep into the economy and raise prices is not exactly clear. In the past, the BoJ has argued that since deflation is a real phenomenon – the product of Japan’s gap between excessive supply and insufficient demand – it is not amenable to a monetary policy fix. But the new policy is working anyway; in July, consumer price inflation rose to 0.7 per cent, the highest in nearly five years. The BoJ is having to come up with a new narrative to explain.

It describes three channels through which the policy is working. One is the lowering of long-term interest rates through its purchases of JGBs. (There are opposing forces at work here, since rates could also be forced higher if markets believe inflation is on its way back.) A second channel is the so-called “portfolio rebalancing effect”. Because the BoJ is lapping up JGBs, other investors are forced to buy riskier assets. The third – once roundly dismissed by the BoJ – is the “expectation channel”: the policy is working because the bank says it will.

The BoJ is coy about saying so but the biggest impact has come from a weaker yen, itself driven lower partly by expectations. That not only helps Japanese exporters, but raises “cost-push” inflation imported through the prices of essential goods, particularly energy. If energy is excluded, July’s CPI rose not by 0.7 per cent but a less-than-thrilling 0.1 per cent. Bank officials understand that a more expensive energy bill does not seem like the most logical way back to economic health. But they argue that higher cost-push inflation will feed through into more general inflationary expectations. “We’ve started the engine,” says one.

As in any good fantasy story, Mr Abe will have to tackle many adversaries before his deflation-slaying quest is complete. He will also need to unleash sensible structural reforms and to control his inner nationalist demons such that he avoids an international crisis with prickly neighbours.

The next big test comes right now. Many, including Mr Kuroda, are urging him to swiftly enact a rise in the consumption tax from 5 to 8 per cent, planned for next April. Taking 3 percentage points of disposable income does not seem the most obvious way of promoting demand-led inflation. A minority of his advisers are cautioning him to hold off and concentrate instead on inflation and growth. All the signs are that he will press ahead with the tax rise anyway. Economists disagree about whether the economy can take such a shock. If Mr Abe gets away with it, we will know for sure he has the luck of a fantasy hero on his side.

david.pilling@ft.com

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