The conflict between Japan’s government and its central bank has taken a new twist. In January, the Bank of Japan finally accepted a 2 per cent inflation target and committed to open-ended asset purchases. Had the BoJ refused the inflation target, the government of Shinzo Abe would likely have proposed changes to the BoJ Law, thus removing, or reducing, the bank’s independence.
This battle between government and central bank is nothing new. What is worth noting, however, is that this time, the market has sided with the government. The Japanese yen has weakened and stock prices have risen. While Masaaki Shirakawa, the BoJ governor, warned that a loss of credibility in government policy could sharply increase the interest rates on Japanese government bonds, the sovereign bond market has remained relatively calm, at least so far. “Abenomics” appears to have won.
The key to understanding the success of Abenomics is the asymmetric response between the currency and the bond markets, which can be attributable to divergent inflation expectations. In the currency market, inflationary expectations rose among investors, mostly non-Japanese, while on the other hand the JGB market remains dominated by Japanese investors, whose inflation expectations appear more or less unchanged.
What excited foreign investors? To be sure, the importance of setting a 2 per cent inflation target on Mr Abe’s initiative should not be understated. But a higher inflation target alone is not enough to achieve actual results. To be successful, it must also be associated with convincing measures from the government. Surprisingly, Mr Abe increased fiscal spending with a ¥10tn ($110bn; 2 per cent of gross domestic product) supplementary budget, (which is expected to raise the 2013 fiscal deficit to 11.5 per cent of GDP), while pushing the BoJ to finance it. On the monetary policy front, the new (as yet unknown) BoJ governor, who replaces Mr Shirakawa in early April, is expected to announce more aggressive easing measures at that month’s meeting, including an increase in the size of open-ended asset purchases.
But will 2 per cent inflation be achieved any time soon? The BoJ’s nine board members’ answer at their latest gathering was a resounding “no”, as their core consumer price index forecast was a mere 0.9 per cent for fiscal year 2014 (excluding the impact from a rise in consumption tax rate). Without structural reform, a 2 per cent inflation target will be hard to hit, even with the help of more aggressive monetary policy.
What are the risks of more aggressive monetary easing and a loss of (or reduced) central bank independence? Some critics argue that it would generate higher (or even hyper) inflation, and raise bond yields. In Japan, this is unlikely to happen, at least in the near-term, as indicated by the current state of the JGB market. However, the other potential risk, which at this stage appears to be more serious, is that the inflation rate fails to rise. It may give the government an incentive to increase spending further and to push the BoJ to monetise it. The JGB bubble will continue to expand.
Abenomics is a great challenge to conventional economic wisdom regarding the soundness of fiscal policy and the independence of central banks. I do not believe that Mr Abe ignores the importance of fiscal discipline or the role of the BoJ’s independence. But at some point, if the leader of Japan faces renewed deflationary pressure and a strong yen, he may draw a lesson from this recent episode that ignoring fiscal soundness and central bank independence is the best way to escape the deflation/strong yen trap. If higher inflation is generated by a persistent increase in fiscal spending, it would be hard to put the brakes on that policy mix; it creates political distortions and can be heavily affected by lobbies that represent the beneficiaries of increased fiscal spending. Eventually, the market would say “no” by raising bond yields, and Japan’s debt sustainability will be at serious risk as debt service costs surge.
In all, we have learnt that when we get out of deflation we may not need central bank independence at first, but it will be needed at the exit when the time comes to tighten policy. That is the only way to generate controllable inflation.
The writer is chief Japan economist at JPMorgan