Markets soared overnight as Bank of Japan Governor Haruhiko Kuroda stunned investors and analysts at the conclusion of the BOJ’s Monetary Policy Committee meeting with the surprise announcement of another dollop of “Qualitative and Quantitative Easing” (QQE).
Indeed, in the run up to the meeting all the chatter on the Street and in the press had been of growing resistance and divisions within the BOJ Board over the ultimate efficacy of Kuroda’s aggressive easing measures to date, and the wisdom or credibility of the ambitious 2% inflation target set by Kuroda and grudgingly accepted by the rest of the BOJ.
But ease Kuroda did, ramming a decision through on a razor thin 5-4 vote – a vote that, we suspect, included probably one less-than-enthusiastic supporter in the yes column.
And as Japanese markets take in this new reality, there are two additional near-term policy items we think key to note:
*** For one, markets are now expecting this additional stimulus to help tilt the balance to Prime Minister Shinzo Abe committing early in December after seeing the July – September GDP numbers to going ahead with the second installment of a planned hike in Japan’s consumption tax, from 8% to 10%, as written in legislation and slated to take effect on October 1, 2015. We believe, however, it is probable Abe will decide rather to postpone the timing of the second tax rate hike, even with today’s economic assist from Kuroda. ***
*** Secondly, last time dollar yen approached the 110 level there were a chorus of voices raised in Japan in protest at the speed and at times even the level of depreciation of the currency. With the dollar trading well through that level now, we do expect to hear renewed protests again from some quarters in Japan over the weakness of the yen. But we believe this move and a further weakening of the yen, if measured in pace, remains firmly consistent if not condoned by financial officials in Japan, even if politically awkward. ***
*** And as part and parcel of policies spurring a Japanese recovery that happens to reflect the fundamentals of differential growth rates between regions, we believe the rise in USD/Yen will also be noted, but not elicit protest from financial officials in Washington either (Congress, Korea, and China could be different stories). We would not be surprised if the USD/Yen rate over time was to settle from the recent 105-110 into a new 110-120 range. ***
To Tax or not to Tax
After months of deliberations in the fall on 2013 Abe decided to go ahead with the first installment of Japan’s consumption tax on April 1 of this year, from 5% to 8%, as planned. The pace and timing of that hike, and a second upcoming installment from 8% to 10%, was written in legislation under a previous government by Japan’s Diet, the parliament, but with an important caveat in allowing a future sitting government to postpone or cancel the hike if at the scheduled time it if were to make an assessment the economy was too weak to weather its impact.
Abe of course did choose to hike the first time around, and the economy was hit hard, harder than expected, and is only now beginning to show signs of recovering.
And at that time, and even now after the effects of the first hike have been seen, Kuroda, himself a former Ministry of Finance official, some of his current BOJ, and all of his former MOF colleagues, were strong supporters of the consumption tax hike for long-term fiscal planning purposes (see SGH 8/13/13, “Japan: Leaning towards Consumption Tax Hike”).
But the sense from political circles in Tokyo is that Abe remains far from determined in his mind to go ahead with the second tax hike yet.
The ruling Liberal Democratic Party is increasingly sensitive to the voices of unease heard among the electorate about weak domestic demand, and the decline in approval ratings for the Abe cabinet has not gone unnoticed.
And despite a good deal of bold talk on the economy and some recent stabilization in the economic data, truth be told the severity of the negative consumer and economic response to the first tax hike did come as quite a bit of a shock, and has left its mark in the halls of Nagatacho.
There is nevertheless little question among Japanese economic and policy circles that the appropriate mix for the economy, with its demographically aging population burdened by high social welfare costs, is probably for a tweak up in consumption tax to pay for those benefits, while offsetting that by stimulating growth through greater investment, namely a cut as promised in the corporate tax rate from the current 35% to “below 30%.”
We do expect Abe to deliver on some modest corporate tax cuts as promised, but the tax cut discussions have been tricky at best, with MOF pushing for a revenue neutral change in the mix which requires the politically challenging elimination of multiple tax subsidies for industries that are currently housed under the umbrella of the METI (Ministry of Economics, Trade and Industry).
And last but not least, the political optics of further disproportionately hitting the lower classes with another consumption tax hike, while cutting tax rates for corporations, is tricky, to say the very least.
Dollar Yen, How High is too High?
When dollar yen approached the 110 level towards the end of last month there were a chorus of voices suddenly raised in Japan in protest at the speed and at times even the level of depreciation of the currency. This helped cap the currency at 110.
USD/Yen was subsequently pushed further back into a 105-110 trading area after the release of Fed minutes on October 8 that revealed the transpiration in parallel of some discussions at the September Federal Open Market Committee among US officials over of the potential negative impact of a rising dollar on US inflation.
A bullish FOMC meeting this week started to turn the USD back higher again, (see SGH 10/29/2014, “Fed: Relax, the Economy is OK”), but that lid was not decisively blown off the old 110 cap until Kuroda’s actions last night.
It is important nevertheless to bear in mind still the ruling LDP party’s political sensitivity to the potential negative side effects of an overly weak currency.
The LDP traditionally has a strong base of support among its domestic constituency in rural areas and with small and medium size business owners. In addition on an economic level there have been concerns that wage inflation may not have been keeping pace with either inflation expectations or import and energy prices.
A falling yen of course benefits large corporations and exporters, but can be to the net detriment of these key political constituencies. And the bulk of the voices raised in protest recently over the yen have in fact come from political circles – and not financial officials.
This prompted Kuroda, under some pressure, to assure the Diet that there was no difference between him and the Abe Cabinet over currency policy.
But the reality is that some gap in tolerance for a weak currency between the BOJ and the government’s economic and financial officials on one side, and the politicians, does exist.
Success nevertheless begets friends, as does necessity, and we suspect if wages and inflation expectations do creep up to close the gap with rising import prices, softened in part by dropping energy import costs, and the economy continues to recover, the resistance to a weaker yen from the political side will not amount to much, either in Japan or from the US.
As to the acknowledgment of global risks and impact of a strong dollar from the US side that markets honed in on so sharply, that also needs to be put in context of the broader outlook of the FOMC, and most especially that of the overall recovery and positive outlook for the US economy (see SGH 10/16/14, “Fed: Not as Bad as All That, Probably”).
The one-two punch of this week’s FOMC meeting with its positive communique – that helped trigger the latest USD/Yen rally –and the strong GDP data that beat expectations on the export side, should go some way in further dispelling market doubts over the resilience of the US economy to a certain degree of dollar strength.
Credibility Gained, Lost, and Re-gained
Going into yesterday’s BOJ meeting, there was a mounting sense of unease in markets and among analysts over the Japanese recovery after the tax hike, waning inflation expectations and impulses, and the potential limitations on further policy options, whether on rates, taxes, or the currency.
Indeed, a sense of resignation was growing even over the wisdom or need to do more on the monetary policy front, despite leaks and universal expectations that the central bank would be revising its 2014 growth forecast dramatically lower, in line with private sector forecasts.
And for our part, while we were expecting Kuroda to push another round of easing through the Board, helping continue to drive the currency even lower in the process, we nevertheless did not expect it to come at this meeting, but to be kept in reserve perhaps until the next meeting in November or even in December.
So it was a bold decision indeed by Kuroda to act, and act sooner rather than wait, in effect borrowing from the Fed tail-wind as well.
We would expect nothing less than continued second guessing of Kuroda’s decision, its ultimate efficacy, rumors of coordination with the Fed, questions over its coincidence with the announcement of the GPIF allocation of pensions into equities, and a potential quid pro quo on the sales tax hike debate.
We would add to that list the announcement by Kuroda that the duration of the BOJ purchases would also be shifted out by 2-3 years, from an average duration of 5-7 years to one of 7-10 years. It is probably sheer coincidence that decision has come on the heels of a little noticed announcement by the Japanese government that for its part it would be shifting its funding and issuance from the short end to include more long and ultra-long JGB bonds for balance sheet management purposes.
In many ways, it certainly makes imminent sense for the BOJ to go further out with its purchases on the higher powered duration curve, even as it continues to buy bonds in the short end at negative rates.
Through all that, when all is said and done, by moving now, Kuroda managed to also openly acknowledge and address the elephant in the room, the drop in inflation expectations away from his all-important target.
Taking action allowed Kuroda and his fellow BOJ Governors to tweak that inflation forecast down in addition to the widely expected downwards revision in the growth forecast, in a surprise to markets and analysts, while at the same time embarking on a powerful policy response in return.
In that he will have re-gained some very valuable credibility, well-earned after his first and highly successful, bold round of QE, but a credibility that recently had been starting to erode.