Recent Developments in Japan's Economy & Monetary PolicyMarch 19, 2014
Takehiro Sato, Member of the Policy Board, Bank of Japan
Ethan Harris, Co-Head of Global Economics Research, Bank of America Merrill Lynch Global Research
On March 19, 2014, Takehiro Sato, member of the Policy Board at Bank of Japan, spoke at Japan Society about the Bank's program of quantitative and qualitative monetary easing, or QQE.
"As a member of the Policy Board of the Bank of Japan, I myself voted for quantitative and qualitative monetary easing last April. It is my strong desire to ensure that it succeeds," Mr. Sato said. "At the same time, in the process of overcoming deflation, the Japanese government's efforts for fiscal consolidation play a vital role."
Today, almost a year after the policy's introduction, "Japan's economy is steadily pursuing its path to achieving the price stability target of 2 percent," he said.
The Bank will closely monitor the impact of the April 2014 rise in the consumption tax rate from 5 to 8 percent. The tax was raised once before, but "in my judgment, Japan's economy is entirely different from that in 1997," when the hike from 3 to 5 percent tipped the country into recession. "Japan's economy has become much more resilient against tax hikes."
Price Stability Target: Not Just About Prices
Setting aside the direct effects of the consumption tax increase, the core CPI—that is, CPI excluding fresh food prices—is expected to grow year-on-year by "around 1¼ percent for some time," and to reach the 2 percent target during the latter half of fiscal 2014 to fiscal 2015, Mr. Sato said.
Achieving 2 percent growth with "surgical precision" is not the point. Like other major central banks, the BOJ seeks flexibility in monetary policy, he said. "What the price stability target aims to achieve is not a situation in which only prices will rise. Rather, it aims to achieve an environment in which the improvement of the overall economy results in higher wages and higher prices."
Thus, there is leeway to take into account "the current condition and the outlook for economic activity and prices," and to analyze risk factors such as the accumulation of financial imbalances.
QQE Mechanism and Long-Term Interest Rates
The QQE mechanism works in two ways, Mr. Sato said. Nominal long-term rates are composed of two elements: the average of the future short-term rates, and premiums. The BOJ's forward guidance on the price stability target "will exert downward pressure" on that average; and premiums "will be prevented from widening through the massive purchases of JGBs with relatively longer maturities."
This "is not different from what happens at other central banks, such as the Federal Reserve and the Bank of England, which also depend on similar unconventional monetary policy." Yet the QQE can't overcome deflation single-handedly, which is why fiscal consolidation is so important.
Fiscal Consolidation and Overcoming Deflation
"From an optimistic viewpoint, if the medium- to long-term growth expectations rise as a result of overcoming deflation, the fiscal structure remains solid despite a pick-up in nominal long-term rates," Mr. Sato continued.
However, the aging of Japan's population "will continue to put pressure on additional fiscal expenditure, such as increasing social security benefits." It will also "constrain the labor supply on the supply side, and change the demand structure of the economy as a whole." With restrained growth expectations, "the fiscal structure will remain vulnerable," and "in my judgment, the fiscal issue will remain even after we manage to overcome deflation," he said.
Developments in the Balance of Payments
The current account balance of payments slipped into deficit territory for the October-December quarter, and will probably remain there for the January-March quarter, Mr. Sato noted. Front-loaded purchases ahead of the consumption tax hike were one factor. Another was fuel imports, which rose "materially" as Japan's nuclear plants remained shuttered.
If the current account deficit persists, and Japan's domestic saving and investment balance shifts from a surplus to a deficit, "the advantage Japan has achieved by financing its deficits through ample domestic savings might change in the long run."
Savings and Investment Balance
Once deflation has been overcome, "excess savings in the corporate sector will likely show a clear decline" as companies become willing to borrow and make investments, he continued. And with an aging population, "economic theory says that the household savings rate will go down," though that may be less of an issue if one takes into account transfer payments from the government and the corporate sector.
In sum, "we should be mindful of a possible decline in domestic excess savings when the QQE succeeds and Japan moves out of the deflationary equilibrium." If the government cannot borrow enough domestically, it will have to borrow abroad—at higher costs—or cut spending.
"In practice, the end of deflation will generate higher tax revenue as the nominal growth rate rises. That is obviously good for fiscal consolidation. Thus, I repeat that it is best to avoid getting trapped by pessimism."
Interest Rates vs. Growth Rates
To gauge fiscal sustainability, it makes sense to compare growth rates "not in terms of long-term bond yields, but rather the average cost of the government's borrowing," Mr. Sato said. "That cost could be higher or lower than the growth rates of the economy. Indeed, the government's borrowing costs have consistently been declining since the beginning of the 1990s, when long-term bond yields began trending downward."
"Most recently, those costs are around 1 percent, well below the nominal growth rates. Under such circumstances, the government has benefitted from an 'interest rate bonus. "
"A pessimist might think it more likely that the government would suffer an "'interest rate onus,' where the government's borrowing costs remain higher than the nominal growth rates," Mr. Sato added. In his view, however, "we will still have some time" to avert such risks.
Potential Impact on the Financial System
If "real rates remain more or less the same," a change in nominal rates "may not be detrimental," he said. Less optimistically, however, abrupt changes in nominal rates "might make the fiscal situation severer, and possibly have an effect on the financial system." To avoid such a scenario, "the Bank has been stress-testing the robustness of Japan's financial system, taking into account possible changes in the interest rate environment. Furthermore, it has urged financial institutions to reinforce their risk management and take measures to enhance profitability."
Ultimately, "it is the market judgment that matters rather than the central bank's intention," Mr. Sato commented. Japan's spending on social security "is not significantly high relative to that in other economies at the moment. However, it is vital that the government makes seamless and tireless efforts to make sure that fiscal discipline remains firmly intact and there is no doubt in the market concerning the government's intention toward fiscal discipline."
Ethan Harris of Bank of America Merrill Lynch Global Research began the Q&A:
What kinds of indicators are you looking at for signs that the pickup in inflation is sustained?
The Bank monitors a variety of data, including the core CPI inflation rate, anticipated inflation rates for the short term and medium to long term, and wages, Mr. Sato said. "Actually there are lots of encouraging signs." A number of leading companies in leading industries have been pressed by the government to raise wages, and have responded "quite favorably and positively." This is likely to become a "wider" trend that extends to other industries and to small and medium-size enterprises as well as large firms.
It's a big challenge for every central bank to explain to the public that "no, we're not trying to make your prices higher. What we're trying to do here is get broad-based increases in wages, prices and incomes that are consistent with a healthy economy." Will the spending increases in Japan balance out the consumption tax increase, or should we be looking for some short-term weakness in the economy?
"There is no question about the tax hike raising the national burden," Mr. Sato said. Household and company purchasing power will be squeezed. "But, again... it is vital for the government to ensure the people's mindset or the people's confidence" that the fiscal system going forward is sustainable, "especially the social welfare system."
Audience members joined in:
Government debt is now over $12 trillion. If it gets to be bigger than household savings, which is $14 trillion now, what will be the consequences, and how will the government handle it?
If the equilibrium between domestic savings and financing debt flow changes—which is "a decent possibility" if the Japanese economy gets out of deflation—"basically the Japanese government would have to rely on foreign capital" for some part of its financing needs, Mr. Sato replied. So "I would repeat that fiscal consolidation is especially important when we get out of deflation."
Where do you want the yen to go, going forward, and what do you expect the yen to do going forward?
"Basically the QQE is not intended to manipulate the exchange rate," which "may move or may not move in response to policy results. But the important thing is that we are addressing the domestic issue, which is deflation. We are combating the deflation. If the borrowing rate moves as a result, it can be acceptable. But we are not intending to move the currency rate."
U.S. households have a very high level of exposure to U.S. equities, whereas Japanese households have a very small level of exposure to Japanese equities. My conclusion would be that the Bank of Japan does not care very much about the level of the Japanese equity market. But I would like to know your view.
That's incorrect, Mr. Sato said. Asset prices, including equities prices, are a transmission mechanism through which the QQE will aid the recovery. Rising prices raise the level of risk tolerance for both households and companies and, consequently, the level of general economic activity.