Can “Abenomics” Transform Japanese Monetary Policy?

Citi GPS Opinion Article

11 March 2013 – Prime Minister Abe has now appointed a new central bank Governor, Haruhiko Kuroda, along with two new Deputy Governors. The key question for financial markets is what will happen next? Will Kuroda and his two colleagues transform the Bank of Japan (BoJ) into an aggressive QE-loving central bank as the Prime Minster hopes? Or will the BoJ continue to manifest more gradualist behavior as in the past?

In a recent research note, my colleague Robert Sockin and I took a turn addressing these questions. Our sense, having previously worked inside a large policy institution, is that direction from the top is influential and important. But so are the views of staff throughout the institution.

Notably, Governor Shirakawa, who has been in his position since 2008, worked his way up as a BoJ staffer over the course of decades. We suspect that there are many others inside the Bank of Japan who share his assessment regarding the limited effectiveness and potential risks of unconventional monetary policies. And importantly, the basis for Shirakawa’s views was not abstract musings but, rather, what he deemed the painful failure of the BoJ’s unconventional policies to jumpstart the Japanese economy during the decade before the global financial crisis.

We thus expect these new senior appointments to result in tensions between the leadership at the top of the BoJ who likely will push for change (consistent with their mandate from the Prime Minister), and staffers more comfortable with Shirakawa’s approach. In addition, we have observed that actually having a hand on the throttle of policy tends to make even bold individuals more cautious.

With Japanese interest rates already at very low levels, our view is that a further easing of Japanese monetary policy will have its greatest effects through weakening of the exchange rate. But sustaining a significantly weaker yen could require a very sizable monetary expansion. Our reading of the empirical evidence suggests that maintaining the yen at 110 against the U.S. dollar might require a doubling or more of the BoJ’s balance sheet. Stronger communication and “announcement effects” could be sufficient to fuel yen depreciation initially, but sustaining the weaker currency would likely require vigorous ongoing asset purchases. The BoJ would eventually need to match it words with actions.

Such a re-orientation of Japanese monetary policy would face powerful headwinds both within Japanese society and abroad. For example, given Japan’s aging population and the large share of pensioners, many citizens may be more worried about inflation — and the potential for negative real returns on their saving — than about deflation, which has assured them of positive real returns.

And a substantial easing of monetary policy would not be warmly received in some foreign capitals. If key emerging Asian central banks loosened policy to allow their currencies to depreciate in tandem with the yen, the stimulus to the Japanese economy would be reduced, but the resulting exchange rate shock for the United States, Europe, and Latin American would be correspondingly larger. We do not believe that “currency wars” is an apt description of the global economy at present. However, if a sizable drop in the yen were followed by meaningful declines in emerging Asian currencies, there is some risk that a destructive series of competitive devaluations might ensue, with negative consequences for global growth and the stability of financial markets.

Given these considerations, we have been surprised by how vigorously financial markets have responded to the promise of increased monetary stimulus from Japan. Since early October, the yen has fallen nearly 20 percent against the U.S. dollar and a broad basket of currencies, and Japanese equity prices have surged by more than one-third.

In contrast, Japanese government bond yields are comparatively little changed on net. If the BoJ was poised to let loose with an inflationary salvo, we would have expected the Japanese bond market to have responded with more signs of anxiety, including intensified volatility, given the low level of yields. One possible explanation is that bond holders are confident that massive securities purchases by the BoJ will keep yields down even in the face of rising inflation. Another explanation is that the domestic investors who dominate this market may be less convinced than foreign investors — who play a more prominent role in foreign exchange and equity markets — that a durable shift in BoJ policy is imminent.

In sum, whether so-called “ Abenomics ” will actually transform the Bank of Japan remains very much an open issue. Our best guess is that newly-appointed Governor Kuroda will bring a more ambitious rhetoric to monetary policy and expand the BoJ’s asset-purchase program. The BoJ will look and sound different than it has under Governor Shirakawa. But ultimately, the pivot in policy is likely to fall short of the expectation s of some market participants. Our observation — after many years watching the Japanese economy — is that things in Japan change only slowly. Perhaps this time is different, but we are not convinced.

Of course, if the BoJ disappoints Prime Minister Abe, the result may be political retribution. Severe scenarios, such as revisions to the Bank of Japan Law, cannot be entirely ruled out. But two considerations leave us hopeful on this score. First, during Governor Shirakawa’s five-year term, he served with six Japanese Prime Ministers. Abe’s previous tenure as Prime Minister lasted only one year. This time he may stay longer, but the churning of Japan’s political leadership has been intense in recent years.

More fundamentally, a well-known body of academic research and practical experience highlights the benefits of central bank independence. This evidence shows that independent central banks achieve superior macroeconomic outcomes over the medium to long term. As such, we are hopeful that Prime Minister Abe, even if disappointed, would not cross the line and violate the BoJ’s independence. The costs to the Japanese economy over time would be substantial.

This caveat noted, however, the ongoing social and political debate in Japan regarding the stance of monetary policy strikes us as entirely appropriate. After nearly two decades of deflation, a spirited discussion about the course of policy is justified. Similarly, for the Prime Minister to appoint BoJ Board members who hold views consistent with his own is in line with appropriate political governance of the central bank. But once those appointees are in place, the government should step back and allow the BoJ to pursue whatever policies that it sees as most consistent with its mandate.