Joshua McCallum, senior fixed income economist at UBS Global Asset Management, and colleague Gianluca Moretti, fixed income economist, see a renaissance at the Bank of Japan.
Over the next year or two, it is likely that headline inflation will be positive in Japan. Firstly, the shutdown of nuclear power stations has forced Japan to import all its energy, so the falling Japanese yen (JPY) will push up the domestic price of energy. Secondly, the government still plans to introduce a rise in sales tax at the start of next year which on its own could add up to two percentage points to inflation.
Unfortunately for the central bank target, both these effects are temporary and both make households feel poorer and hence work against the stimulating effects of QE. So, for technical reasons, the BOJ should temporarily reach its 2% target in two years, but to stop inflation reversing it will need to tackle expectations. There are some hopeful signs: the inflation rate implied by five-year inflation-linked bonds has risen by more than half a percentage point since the start of the year to 1.4%.
Unsurprisingly, the JPY fell on the announcement that the BOJ would double the supply of money over the next two years. This depreciation is arguably just a reversal of the appreciation that the JPY experienced when the BOJ was lagging behind in monetary easing. This is not a sign that Japan is engaged in a currency war, but undoubtedly a weaker exchange rate is part of the desired outcome (see Economist Insights, 28 January 2013). This will mostly be upsetting for countries like South Korea and China, but the irony of those countries complaining about currency manipulation will not be lost on the rest of the world.
Bond investors in Japan are in for perhaps the biggest shock of all. The BOJ will now be buying more than the entire net new issuance of Japanese government debt. Private investors will be squeezed out of the market, and no surprise – this is one of the key objectives of QE programmes. By buying up government bonds, investors are forced out into riskier assets, such as corporate debt or mortgages, which has a knock-on effect through all asset classes. Witness the precipitous rise in the Nikkei as soon as prime minister Abe (pictured) started to push for the BOJ to change direction. Investors may also choose to invest overseas in search of higher returns, which would also put further downward pressure on the currency.
With the BOJ moving from being the laggard to becoming more like the Fed than the Fed, the European Central Bank (ECB) has now become the laggard. Last week the ECB kept policy unchanged despite the deteriorating economic and political outlook in the Eurozone. ECB President Mario Draghi effectively suggested that there was nothing more that the ECB was able (or at least willing) to do. Unless the ECB can bring about any new surprises (like its own version of QE), it will end up looking a lot like the old Bank of Japan.