Japan or how to be an example of the limits of monetarism

By Gilles Moëc, Chief Economist at AXA Investment Managers

Japan is in the spotlight at the moment, given last Friday's leaks about the replacement of Bank of Japan Governor Kuroda, which sparked feverish speculation about the timing and magnitude of the expected monetary policy change. 

On the face of it, the excessive money growth in Japan has been very similar to the profile seen in the US and the Eurozone, with a peak during the pandemic already under correction. However, the scale is very different. Between peaks, excess money growth has been particularly slow in the Asian powerhouse, despite extreme monetary policies, averaging 1.4% per year between 2010 and 2019, compared to 2.0% in the Eurozone and a robust 3.4% in the US, reflecting the ranking in terms of inflation "performance" at the time. 

Against this backdrop of rising inflation, pressure has been building on the BOJ's current stance, with the central bank torn between, on the one hand defending yield curve control (YCC) at all costs, implying that it has de facto lost control of its balance sheet, or on the other, accepting a weakening currency that would further fuel inflation. With the departure of Governor Kuroda in April, a window of opportunity opens for a policy change.

The government's unexpected choice of Kazuo Ueda, an academic, rather than a continuationist candidate from the current central bank leadership could be interpreted as signaling an accelerated break with the YCC. This was the first market reaction, before analysis of Ueda's views prompted a rethink. His public assertion that the BOJ's current stance is "appropriate" can be understood as a willingness to "not rock the boat" and proceed with caution. 

We can see several reasons for caution. First, although inflation has returned, it is still significantly lower than in the US and Europe, and one wants to make sure that it is not going to end up as a one-off "supply shock" but actually filter through to wages. The results of the next round of wage negotiations will be crucial. Second, the consequences of resigning from the Chamber of Commerce and Industry may be significant. A simple "fundamental" model of the Japanese 10-year yield would suggest that, but for the Bank of Japan's intervention, long-term interest rates would be 1 to 1.5% higher. Even disregarding the risk of technical overreaction, this would be a big jump, returning us to yields not seen in more than 15 years. The same model suggests that the influence of US interest rates on the Japanese yield curve is significant, again when controlling for the Bank of Japan's efforts to counteract it. Tactically, the BOJ may be tempted to wait for the Fed to "finish" before acting.

Finally, the central bank has to decide what operating framework to follow once the YCC is over, with two sub-issues: what to do with the policy rate and whether or not to let the long end of the curve move freely. A bit of "discretionary QE," in which the BOJ tries to steer the bond market to avoid overreactions but without revealing an explicit target, may be a temptation. Resolving these issues may take many months after Ueda takes office in April and we may have to wait until 2024 to act.

However, while we may not expect any rash decisions in Japan, with Kuroda's departure it appears that the "last dove standing" will also be leaving the world stage. Ueda, in an interview with Nikkei a few months ago, warned against hasty decisions, but made it clear that change is on the way: "it is necessary for the Bank of Japan to prepare its exit strategy". The fact that the Bank of Japan will normalize its monetary policy, even if later than other major central banks, will show that monetary policy will not return to "pre-pandemic" times.