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Analysis
Yen decline looks likely as Abenomics slows down

Yen decline looks likely as Abenomics slows down

Dual policies on interest rates and inflation over asset purchases

by David Marsh

Mon 16 Dec 2013

The outcome of continued Japanese monetary easing, coupled with only lacklustre results achieved so far in stimulating the economy under Shinzo Abe’s government in power now for nearly a year, is almost certain to be a further prolonged fall in the yen. A slide from the current 103 to the dollar to perhaps as low as 110 could ensue, possibly testing how far the Japanese authorities wish to see the currency decline before sparking potential inflationary dangers.

All the signs are that the Bank of Japan (BoJ) will carry on doing ‘whatever it takes’ to raise inflation into the 2% range from the current 0.9%. Crucially, the so-called third arrow of 'Abenomics' – structural reform of the Japanese economy – has turned out to be relatively unimportant up to now, so the authorities may be relying more on a weaker yen than might otherwise be the case as a key method of achieving 2% inflation.

Depending on how the economy performs over the next 12 months, there is even speculation that government bond purchases of ¥50tn a year under the bank’s so-called quantitative and qualitative easing programme could be stepped up under the plan to double the monetary base within two years and end the country’s 15-year deflation.

Renewed signs of the BoJ’s undaunted pro-easing bias have emerged at the same time as indications that the Ministry of Finance (MoF) and the BoJ are following an overt interest rate policy through the asset purchase programme. Over the period since ‘Abenomics’ was unleashed in January, 10 year government bond market yields have hardly changed at around 0.7% despite a 50% rise in the Nikkei index.

Comforted by the BoJ’s massive monthly purchases, bond market investors have been more or less ignoring the signals of higher inflation in the pipeline – which would normally be reflected in higher yields. Stock market investors, on the other hand, have been following the opposite line, building into their valuations and projections of equity price performance the expectation that Japan will indeed soon be posting 2% inflation.

This is a somewhat shaky equilibrium that cannot be sustained indefinitely. The explanation to this apparent conundrum appears to be that the authorities are overtly targeting bond market interest rates as well as the monetary base in the asset purchase program.

The aim is to ensure that Japanese government bond yields rise (and bond prices fall) only several months after inflation has hit the 2% target.

At the same time, it seems clear that a much-rumoured asset-purchasing switch to the equity market from the bond market by the government pension fund, a key holder of Japanese government bonds with a total of more than $1tn under management, is not going to happen any time soon.

All this gives is a virtual safety net to investors in the bond market, which has the effect of dissuading large scale asset sales – at least for the moment. Signs that Abenomics is in for a long haul – and therefore BoJ asset purchases may have to be kept going for longer than initially foreseen – have multiplied from several directions.

The annualised rise in GDP growth of just 1.1% in the third quarter announced last week, down from the 1.9% in preliminary data, was a disappointment for those wishing to see firm evidence that the economy was back on the expansion track.

Moreover, part of the latest 0.9% inflation rate – hailed by Kuroda as a sign that the reflationary plan is ‘almost halfway’ towards completion – has been caused not by home-grown inflation (including much-needed domestic wage growth), but by higher prices for energy and imported goods induced by the lower yen.

Perhaps most preoccupying has been the realisation that the enormous increases in underlying liquidity in the economy, registered by the monetary base, have not fed through to stimulating the money supply or bank lending.

Just as has been happening in Europe, extra liquidity has been deposited for ‘safekeeping’ reasons at the central bank, or has been lent abroad – so that Abenomics is probably benefiting Cambodia or Vietnam as much as Japan.

According to data compiled by Richard Koo, Chief Economist at Nomura Research Institute, money supply (M2) on the basis of 1990=100 is still only 186 in Japan, while bank lending is still more subdued at 106.

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