Paul and Luke talk to Sree Kochugovindan, senior economist at abrdn, about the return of inflation to Japan, and the outlook for Bank of Japan monetary policy as a response. Negative interest rates and yield curve control could end in 2024, if wage growth and inflation expectations continue moving higher. 

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Paul Diggle

Hello and welcome to Macro Bytes economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn

 

Luke Bartholomew

and I'm Luke Bartholomew, Senior Economist at abrdn

 

Paul Diggle

Now, for a long time forecasting the monetary policy decisions of the Bank of Japan has been as simple as predicting no change, while the BOJ as they are known, were a pioneer of zero and in time negative interest rates and quantitative easing. For much of the past five years, there's been a few fireworks. But that's all changed during 2023 with the emergence for the first time in many decades of inflation pressure in Japan, causing a rethink of monetary policy settings there. So it suddenly got a lot more interesting in terms of the Japanese monetary policy outlook and to discuss all this, discuss what lies ahead for Japanese monetary policy, I'm very glad to be joined by Sree Kochugovindan, Senior Economist at abrdn. Welcome Sree.

 

Sree Kochugovindan

Hi, Paul. Hi, Luke.

 

Paul Diggle

So Sree, let's start with a bit of recent context. Tell us about current Bank of Japan policy settings, and the recent tweaks that they've made to those to yield curve control and so on.

 

Sree Kochugovindan

Yes, I mean, there's been after decades of no change in policy, as you say there has been some recent tweaks within that. And that's really come after a year of intense pressure on Japanese assets and markets have really been testing the BOJ’s resolve to maintain ultra-loose monetary policy. So the changes really started last December, December 2022, when we had a doubling of the band around the 10-year JGB trading band. So this is what we call yield curve control. Where the 10-year JGB yield is pinned to 0%. But there's an allowable trading band around that. And that was doubled from 25 basis points to 50 basis points. So that was last December. Now that had come after a year of intense pressure. And just as investors had given up hope, then they moved in December when it was very quiet. Then, in July, again, we had a shift in policy. And this time, they delivered a flexible tweak around those yield curve control settings, or YCC settings. They voted to maintain the official band the same, but they allowed a greater deal of flexibility, and that essentially widened the trading band by 50 basis points to 1% - plus or minus 1%. And at the time, again, the market consensus had completely priced out any policy change. And then that's when they moved. The recent change that we saw was in October, they allowed again, further flexibility to yield curve control settings. The upper bound of the trading band remains 1% but that's no longer a rigid ceiling, but a reference rate. So again, flexibility. So they are steadily moving, stepping away from this rigidity that we've seen over the past few years. And they're opening the door towards an exit eventually. And timing of which is something that's been a great debate for many months now.

 

Luke Bartholomew

So I think Sree, this concept you talk about of the market testing the resolve of the Bank of Japan speaks to something really important, which is about credibility, right, the Bank of Japan's credibility. And I think of this playing out in two ways. One, just the way in which yield curve control works. The idea is that if you set a yield level, which is credible, it might be that you don't have to do very much in terms of market interventions, right? But the fact was that they were setting a yield level that the market didn't think of as being very credible. And that led to a huge ballooning in the balance sheet. And in a sense, that's sort of what's causing some of these issues that's making it step away. And then the second is, you were talking there of tweaks. And that's absolutely how the Bank of Japan describes it. But, you know, with those three moves that you described, effectively, they have quite significantly tightened financial conditions effectively. So it's one thing to call that a tweak as they do, but the credibility with the market in saying that has to be somewhat reduced by the fact that there really are quite substantive policy implications that flow from this. So yeah, I think your idea of sort of the market testing the Bank of Japan is, is really important in that sense. But perhaps just sort of taking a step back and talking about why they felt the need to introduce yield curve control and some of these unconventional policies. People talk about Japan having several lost decades. So do you want to talk us through sort of what the cause of this was and what was happening to growth and inflation in Japan during those lost decades?

 

Sree Kochugovindan

Yes. So just to try and do this as a brief overview of the last 30 years. But the lost decades you could say started from 1991 arguably to as late as 2021. And it really started, the root of all of this, was the bursting of the asset bubble in the late 80s. There were some natural disasters, but also inappropriate monetary and fiscal policy settings. And as well as the structural challenges that you find from the demographic shifts that are still ongoing. So if you look at the averages over the last three decades, GDP growth, just averaged 0.7%, and inflation was averaging 0.4% over this period. Now, growth and inflation did attempt to accelerate on several occasions, but failed to really fully break out of that trend. So really, this goes back to the bursting of the credit and stock market bubble of the mid-90s. Land prices started declining for about 15 years, stock market volatility went up quite dramatically. And all of this weighed heavily on the growth outlook. So the large output gap had been the main, the dominant driver for deflation for many, many years. And the BOJ has really been on the cutting edge of alternative policies. I mean, the BOJ cut rates to 0.5% in 1995, which was unprecedented at the time. The move towards zero interest rates in 1999 - again, unprecedented. But deflation had already set in and Western core continued to fall all the way through to 2011 and stayed in deflation, for many for many years. Now, since then, politically, there have been a number of changes, the second election of Prime Minister Abe brought with it some political stability. And that came after a period of six prime ministers in the course of six years. And he introduced the three arrows approach, which has been, was just become quite familiar to many people. But the approach was of aggressive monetary policy, and fiscal stimulus, which is funded through tax incentives and structural reforms, as well. So with all of that, there was initially some hope that inflation would really finally reemerge. But the supply side of the economy did not improve during that period. And despite the growth focus policy, potential growth and productivity growth remained quite weak, and inflation remained flat at best. So ultimately, this history highlights that longer-term damage caused by lack of nimble and adequate policy responses can be quite damaging and quite persistent. And Japan continues to face structural challenges. So tightening policy too early, as you noted earlier, Luke, there has been a tightening at the moment. So that is a familiar mistake that obviously the BOJ seem very very keen to avoid. Hence, the communication through all of this has been incredibly cautious and attempted to be neutral with regards to inflation and the wage outlook as well as policy.

 

Paul Diggle

Yeah, that policy discussion there Sree strikes me as incredibly important because, you know, one conception of a central bank by economists is that the central bank does ultimately set the price level. So even if you're experiencing asset price shocks, demographic headwinds. In the end, the central bank sets the price level, at least under certain economic models. So a failure to meet your inflation target over a long period of time is in a sense, a policy failure. It's a sign of the central bank just not having done enough. And that's despite the fact that Bank of Japan has at times, as you say, been a pioneer in introducing zero negative rates, quantitative, easing, and so on, in many cases, decades ahead of the Fed and ECB and the Bank of England doing so. Abenomics, three arrows, another attempt at making policy more forceful. But even then, clearly, policy just hasn't been forceful enough. So if the lost decades ran right up through Abe’s term as well, right up to the pandemic, things then appear to have changed post-pandemic because, much like many economies Japan coming out of the pandemic experienced a surge in inflation. Tell us how high inflation gets in Japan. What were the drivers of Japan's post-pandemic inflation increase?

 

Sree Kochugovindan

Yes. There has been a shift clearly, and this is what's really driving some of the investor speculation as well, this shift in inflation. So headline and core measures of inflation reached a 40-year high in 2022 and early 2023, and it picked up more than double the 2% inflation target that’s set by the BOJ. So that's quite an important point. And one of the drivers of the speculation. However, the BOJ refer to a lot of these drivers as pandemic-related and transitory. They still have this transitory view. So global factors such as commodity price increases, supply chain bottlenecks, those have been key drivers of certain aspects of Japanese inflation. Now, some of the energy price impact has been muted in Japan because governments have implemented subsidies for utilities and for gasoline prices. And that's helped constrain some of that energy price increase relative to other developed markets, for example. But goods price inflation actually peaked in June 2022. And that has declined quite considerably and is set to decline further. And this is part of that global story of supply chains improving. Imported raw material prices have declined for Japan. And that actually is a leading indicator for goods prices by around eight months or so. And it actually signals further deceleration in goods prices ahead. Now, if we then look at the other side of inflation, we look at service sector inflation that actually lagged the trends in goods sector and in commodities. So this domestically generated inflation has been a bit slower to improve, but it has moved higher and core services inflation is now close to 2%. On some measures of core services, excluding imputed rents, they've exceeded 2%. So this is quite positive news. This has been the first summer for Japan without any COVID warnings, or some form of restriction. And so that's really boosted this pent up demand for services and the breakdown of inflation shows pockets of price pressures across recreation, food, hotel charges, inbound tourism was quite strong this summer. So all of this has started to feed through and it looks as though services prices are normalizing. However, the BOJ remain quite cautious still, because for them, really what is important is a meaningful acceleration in wages. And that's what will be required to drive sustainable improvements in services inflation, and inflation, headline or core inflation at sustainably stronger levels and closer to target. So there is still a degree of caution despite what we're seeing in the underlying numbers there.

 

Luke Bartholomew

So wage growth is clearly crucial to getting inflation to stay around target consistent levels. And of course, Japan has a slightly unusual labour market in the way in which wage negotiations take place the so-called Shunto wage rounds that happen in the spring of each year. And I guess what makes this a particularly crucial Shunto round is that we, as you described it Sree, we've had this, you know, huge by Japanese standards pickup in inflation without nominal wages doing very much and that means real wages have been eroded. And the worry then is that that sort of leads to macroeconomic weakness, which undermines the very inflation that Japan's trying to create Now, the government had a few fiscal packages to try and bridge it through to next year. But what really do you think we need to see from next year’s Shunto in terms of wage negotiations for us to be comfortable that there is something like a virtuous, and it's not often that a wage-price spiral is called virtuous, but a virtuous wage-price spiral to develop in Japan?

 

Sree Kochugovindan

Yes, I think that just to look at what happened this year, the 2023 Shunto wage negotiations were the strongest since the early 1990s. And that resulted in a 3.6% wage hike from the negotiations compared to a previous year of just 2.1% in the fiscal year of 2022. So there's some optimism there that strong corporate earnings, and also a government led drive, which continues, a government encouragement for higher wage growth, particularly among smaller companies. So this has been a key trend so far. However, what we've seen and something that the BOJ have been quite concerned about is that these wage negotiations haven't really fed through into realised earnings. So if you look at scheduled earnings, they're still in the region of the base earnings, the core earnings taking out bonus spikes, that's still in the region of like one and a half percent annual growth rate. So that's still a bit disappointing. So now heading into 2024 the firms have already started to announce plans to raise wages that are higher than last year. And this is all quite staggered, so the larger companies start to announce sooner, and then it takes a few months for the smaller companies, the smaller unions to really start to follow suit. But we could see another 3% or so in the Shunto wage agreement next year. And that could then lead into slightly more positive realised earnings. But it takes time, it takes time. So this, the impact of reported earnings is really what the BOJ has been focusing on. But the trend has shifted somewhat in terms of negotiations, at least.

 

Paul Diggle

Yeah, this distinction between the Shunto centrally negotiated wage round, and then realised earnings. That's an important one, right? Because if one looked only at Shunto and said, yeah, at three, three and a half percent, you know, it could be another decent year in 2024 signalling from firms based on their announcements as they will be targeting a centralised wage hike around that kind of level. There's also obviously a decent corporate earnings backdrop as well helping. That, of course, sounds pretty good target in the context of meeting a 2% inflation target. But yeah, as you rightly say Sree that’s something different to actual cash earnings, realised earnings, and one crucial part of that difference, as far as I understand it is that the Shunto numbers include the seniority-based changes in wages within the lifetime employment system, so moving up the seniority scale effectively, but what we need for economy-wide cash earnings to rise to something like an inflation target consistent level is a shift up in the entire wage scale, not just you know, service-related increases, due to length of service and so on. And, you know, these distinctions, these important differences in the data also exist in the inflation data, with Japan measuring particularly core inflation differently to many other Western economies. So I think there’s a lot of importance there on having a proper understanding, as you have, of the Japanese economy. But I want to ask you about considerations beyond just inflation, wages, slightly higher inflation expectations, because the Bank of Japan, and also many people in financial markets, have pointed to issues of financial market functioning, and also rapid yen depreciation as potential reasons for the Bank of Japan to change its policy settings. What's been going on with market functioning? What's been going on with the yen, which have also led to pressure to exit current monetary policy settings?

 

Sree Kochugovindan

Now, this is something that's really important for the BOJ and they actually mentioned this in the latest press conference and in the latest statement. So the Bank of Japan has really been a monetary policy outlier since 2022. Every other central bank, developed market central bank, has been going through an aggressive monetary tightening process, and the Bank of Japan has not. So this gap between JGB yields and global bond yields has really widened. And that differential has been part of the pressure for Japanese bonds, but also for the yen. And it's really led to a sharp deceleration in the yen over the course of the last, say 12 months or so. Now, both of these actually have led to some pressure for the BOJ, but the government is starting to, some of the government measures, we mentioned fiscal policy earlier, there is support from the government in terms of trying to encourage some of the domestically generated inflation pressures. Trying to encourage wage growth among smaller companies. So, there is some coordination there. However, the focus for investors has very much been on the fact that bond market functioning has been distorted - seeing very poor liquidity for about a year or two now. Price discovery has been very difficult. It's made for a very difficult trading environment for investors. So combined with that perception that inflation has overshot it's led to this consistent attack on what, you know, it's like an attack on the peg for bond yields, in essence over the last 18 months or so.

 

Luke Bartholomew

So bringing all this together then Sree, the concerns around market functioning, yen depreciation, signs that inflation has been picking up (but a far from slam-dunk case on that), the importance of wage growth in next year’s Shunto in particular, putting all of that in balance, where does that leave us in terms of where we think the Bank of Japan's policy setting is going to move to over the next year or so?

 

Sree Kochugovindan

So the communication has been consistent in some sense, in that it's really focusing on the global and transitory nature of inflation pressures. The second part is there's a real focus on the wage growth in 2024, and the Shunto negotiations for 2024. But what we've seen, in essence is step by step an adjustment in terms of policy, which we outlined earlier. So all of this points to potentially a shift in policy, once we start to get some greater clarity from the Shunto negotiations next year. So I'm actually of the view that we'll start to see further adjustments next year, and potentially an adjustment in yield curve control, but also a move in interest rates away from negative interest rates towards zero interest rates from April onwards. Most likely the timing could be around June, July. At the July policy meeting, there is the opportunity to express this more clearly through the economic outlook and the forecast changes. So far what we've seen this year is a steady adjustment higher in the inflation forecast, the near-term inflation forecast, however, the fiscal year 2025, the longer-term forecast remains below the BOJ target. So that's a way of signalling yes, we've seen some improvements, but we're not fully convinced that we’re reaching target. So it’s a way of communicating around the economic outlook, which is why July seems like a good timing. They could move earlier than that. All of this is, you know, this is quite a close call. It's very, very difficult to really judge the BOJ going forward. Given their communication hasn't necessarily been very very clear, always. But if we try and think well could they adjust policy sooner? Well, in April, there are a number of March / April, we have a number of end of fiscal year liquidity issues need to be considered. There's also Golden Week as well, where there's a one week holiday, so that will possibly affect liquidity following an April move. So putting all of that together, we could see a shift around the June, but most likely the July, policy meeting. But obviously this is a very close call. And it all really hinges upon the wage outlook, but also more convincing behavioural shifts because we need to take into account expectations. And the problem that Japan has faced is that it's very very difficult to pass through price increases when you see consumers shifting their behaviour quite quickly, because they've really become very very used to thirty years of this deflationary disinflationary mindset. So it's gonna take a lot to change that. And I think there's a number of, you know, risks around the call, unfortunately, but we also need to consider the fact that market functioning is a consideration. The BOJ is a big outlier compared to other markets. And is it really necessary to have such a big gap in terms of policy rates?

 

Luke Bartholomew

It's interesting that you called the Bank of Japan an outlier there in the sense of the last couple of years keeping policy on hold, albeit yield curve control is itself a sort of form of policy tightening, whilst other central banks have tightened significantly. And then next year, as you described it, there a very close call, but our baseline being that yield curve control gets lifted further, and we see the end of negative interest rates. So the Bank of Japan lifting interest rates at the same time, when many other developed markets, central banks could very well be cutting interest rates. So perhaps Japan ends up being an outlier from the other side, although I suppose it is important to sort of put in context, whilst sort of, rhetorically symbolically the ending of negative interest rates is a significant moment, that a 10 basis point move that we're talking about from minus point one to zero is pretty small in the scheme of things, albeit the Bank of Japan has probably been quite an important anchor for global bond markets recently. We talked about this in our term-premia episode. But anyway, I think that is all that we have time for this week. So as ever, please do let me ask you to subscribe and rate us on your preferred podcast platform. And all that remains is for me to thank Sree for joining us today and her excellent contributions and to thank you all for listening. So thanks very much, and speak again soon.

 

 

 

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