Since February 1999, the Bank of Japan has provided de facto zero interest rate funding to Japan and the world. Now, Governor Kazuo Ueda has hiked rates. Twenty-five years of ‘capitalism with a zero-cost rate anchor’ is coming to an end. Sayonara financial socialism.
And welcome back inflation. In the days after ending negative and zero rates, Ueda stressed that a key reason for raising rates now was to avoid being accused of doing ‘too little, too late’. Being too late raises risks of having to hike at a more aggressive pace in the future that does not allow due time for markets to adjust to Japan’s new realities. Ueda prefers proactive gradualism to reactive radicalism.
Is a wage-price spiral on the cards?
It’s painful to contemplate, but Japan’s inflation risk profile may be changing faster than generally anticipated. What started two years ago with global supply- and terms of trade shock-induced price increases is now on the cusp of turning into a potentially dangerous domestic wage price-led, demand-pull inflation spiral (Figure 1).
What else are we to conclude from Japan’s ‘shuntō’ base wage negotiation result? After almost 20 years of flatlined base wage hikes of around 1.5%, the shuntō went to 3.6% last year and has now jumped to 5.3% (well above the 4% expected by experts).
Over the past 20 years, inflation has been de facto zero (i.e. real base pay purchasing power rose by around 1.5% each year). Last year, inflation was 3.1% (real base pay wages rose 0.5%), but this year it will run at just above 2% according to the BoJ policy board forecast. The shuntō coming in at 5.3% means workers’ real purchasing power should rise by 3%, more than double the 1.5% average growth over the past 20 years.
This obviously sounds great for domestic consumption. But the problem is that the BoJ has zero control over the labour market in general and wage inflation in particular. All indications are that Japan’s labour market will tighten further.
The skills mismatch will intensify and most likely compound: the number of high school and university graduates is declining, but the demand for specialised workers is rising. Locally, the gap could be filled by the retiring ‘Showa’ baby boom generation, but unfortunately these are mostly generalists who will need significant re-skilling and greater pecuniary incentives to re-enter working life.
Figure 1. Who is afraid of a wage-price spiral?
%, year on year
Source: Bloomberg, Jesper Koll
Note: CPI adjusted for VAT hike distortions.
At the very least, the time has come to be open to a complete re-think of how to assess Japanese monetary policy priorities. After the ‘lost decades’ of increasingly bolder actions taken to get out of deflation, slowly but surely the pendulum will swing towards policy actions specifically designed to rein in inflation.
Fortunately for Ueda – unlike in the US or Europe – in Japan, ‘demand destruction’ policy levers can be pulled from both the monetary and the fiscal side. Specifically, Japan’s next recession is more likely to be triggered by tax hikes than by Ueda hiking rates too fast and too aggressively.
Practically speaking, Ueda is poised to stay true to the macroeconomic legacy of his predecessor Governor Haruhiko Kuroda. Real policy rates are bound to stay negative for the foreseeable future. This is poised to be supportive for yen risk assets – equities, real estate and non-yen securities.
Searching for the new normal
Make no mistake: Ueda faces a heroic task. He must lead markets and the economy towards a new normal, away from decades of central bank-led ‘emergency’ actions that did more to suppress debt capital market price discovery than end deflation. And now that inflation is finally here, nobody has any idea where – or how – Japanese inflation expectations will be anchored next.
After the BoJ consistently missed its 2% inflation target on the downside for almost three decades, private sector actors may be forgiven for not trusting the bank will achieve it now that inflation has shot up to above the target. Yes, a first hike in rates will be presented as a vote of confidence that deflation has ended. But it does not follow that inflation will be contained.
Fortunately, Ueda knows better than anyone that he must be humble and admit that, as he starts the journey of normalisation, he does not know what interest rate level is the optimal new-normal neutral. This does not mean he is starting completely without references: apply the Taylor rule to today’s Japan and you get a Taylor rule neutral rate of slightly higher than 2% for the correct policy rate anchor.
No matter how theoretically sound, for all sorts of reasons there is no way for the BoJ to communicate and guide towards 2% when starting from zero – it’s about four times above what market participants and forecasters expect. Even after the hike, most economists still expect a terminal policy rate anchor of around 0.5% in this cycle. My own forecast is for something closer to 2%-2.25% as I expect Japan’s nominal gross domestic product growth to surprise very much on the upside over the next 12-18 months.
What about Japanese capital markets?
Japan’s capital markets are now primarily driven by long-overdue corporate actions to put ‘lazy balance sheets’ to work. Last year’s initiative by the Stock Exchange to hold its member companies’ chief executive officers accountable for driving price-to-book ratios above one has become a catalyst for unprecedented corporate action: record business investment spending, record mergers and acquisitions and management by objectives activity, relentless increases in dividend hikes and share buybacks.
It is not an exaggeration to state that, finally, Japan’s corporate leaders are becoming real-world capitalists. The Bank of Japan terminating its brand of financial socialism will not, in our view, negatively affect this positive capital markets momentum. On the contrary, as both labour costs and debt capital costs are poised to rise further, the less productive and inefficient companies will be forced to either fundamentally restructure or make way for the more efficient players.
More than anything, the BoJ’s decision to end financial socialism and outright market intervention is not just a statement of confidence, but an official endorsement – capitalism is coming back to Japan.
Jesper Koll is Global Ambassador and Expert Director, Monex Group, Japan.
The economic outlook for Japan will be further explored in a roundtable on Monday 8 April. Register to attend ‘Lift-off for the Bank of Japan‘.
