The BOJ’s next step down a narrow path

Hiroshi Ugai, Head of Japan Economic Research and Chief Economist for Japan at J.P. Morgan

First published by The Japan Times

Six and a half years after unleashing massive monetary easing, the Bank of Japan failed to raise inflation as planned. Now clouds hang over the Japanese economy — as they do others worldwide — because of the U.S.-China trade war, slowing global growth and rising economic uncertainty.

Other central banks will likely release fresh rounds of monetary easing, but the BOJ is out of ammunition. It bought up almost every asset it could by driving interest rates down. Having shot its “bazooka,” what can the BOJ do next to tackle a future recession?

Hiroshi Ugai, chief economist at JPMorgan Securities Japan Co. and a former BOJ staff member, believes the central bank must enter a new agreement with the government. The previous agreement, issued

Economists interpret the joint statement to mean the BOJ would do “whatever it takes” to reach 2 percent inflation, provided the government took flexible measures to grow the economy in fiscally responsible ways.

The BOJ would greatly expand the money supply, while the government launched structural reforms with an early round of fiscal stimulus. After the spending boost, further monetary easing required continued fiscal consolidation in accord with the joint statement. This included ongoing consumption tax hikes — to signal the government’s intent to bring yearly budget shortfalls and national debt down to sustainable levels.

The BOJ wholeheartedly kept its side of the bargain. The government also did, with some foot-dragging. It lifted the consumption tax from 5 percent to 8 percent in April 2014. But it twice postponed the planned October 2015 rise from 8 percent to 10 percent, after the 2014 hike caused a consumer spending slump. The tax increase is now scheduled for Oct. 1.

The BOJ introduced quantitative and qualitative easing in April 2013. It continued to expand its balance sheet, buying up assets even when government reforms and stimulus proved less impactful than desired. When the BOJ still missed hitting the inflation target, it introduced negative interest rates in January 2016. The yield curve flattened and long-term yields tumbled, pinching financial firms’ profit margins. Negative yields put the nation’s financial plumbing at risk. The BOJ also worried that more easing might cause household sentiment to waver, over fear that unprofitable insurance firms would jeopardize the sustainability of the social security system.

In September 2016 the BOJ introduced yield curve control into the mix, to preserve slightly upward sloping interest rates with the 10-year yield pegged around zero percent. The measure safeguarded financial institutions’ profit margins by preventing the long-term yield from falling any lower. They also introduced an inflation-overshooting commitment, but this failed to lift inflation expectations.

The central bank could do no more.

Guidelines now call for the BOJ to buy ¥80 trillion of sovereign debt yearly. In practice, it spends less than ¥30 trillion each year managing the yield curve. The BOJ currently owns 40 percent of national sovereign debt. “If they turn to the original QQE and try to increase purchases to ¥90 trillion, by 2025 the BOJ would own almost 100 percent of the JGB market,” notes Ugai. It also owns 90 percent of the exchange-traded fund market — equal to about 5 percent of the Tokyo stock market. Buying more ETFs would put the BOJ’s credibility as an independent institution at increased risk should a sudden plunge in stock prices force its recapitalization by the government — an outcome best avoided.

In theory the BOJ could start buying other risk assets if it receives approval from the Financial Services Agency and the Finance Ministry. But what would be the purpose?

The BOJ’s own research suggests that lower long-term yields would have little impact on the real economy. It might negatively impact long-term investor and household-sector sentiment. A better alternative is to lower the short-term policy rate, currently around minus 0.1 percent, but it could not do so by much.

If they tried, banks might start passing on to depositors as “fees” the interest that banks pay to park unutilized cash at the central bank. Below minus 0.5 percent, however, depositors would find it cheaper to store cash in vaults. Ugai therefore thinks the lower bound short-term policy rate under normal circumstances is about minus 0.5 percent.

The BOJ today has few good choices. It lacks effective tools to get Japan out of recession, should it fall into one. To add to its toolkit, Ugai recommends that the BOJ enter a new cooperation agreement with the government.

Under his proposal, the government would expand fiscal spending while the central bank keeps low yields during periods of recession. Both institutions would cooperate during the downturn to achieve growth and inflation. When the economy returned to normal, the government would again pursue fiscal consolidation. “If Japan moves into recession, their only remaining power tool would be a policy mix of a large expansion in fiscal spending and low yield curve control,” Ugai suggests.

His proposal is not without risks and challenges.

On what would the government spend? It has already spent too much on infrastructure. There is a tight labor shortage in the construction industry, so building more is wasteful. The government could gift money to households, but people would likely save rather than spend, given the nation’s deflationary mindset.

Ugai suggests using fiscal stimulus to jump-start needed structural reforms. For example, government aims to reform the labor system. If it succeeds, increased labor mobility will raise the unemployment rate. “I think that fiscal spending should strengthen the unemployment safety net,” Ugai argues.

A weakened BOJ must also convince investors that the government would (and could) fulfill its end of the bargain. If it failed to do so, credit agencies, sensing moral hazard, would likely downgrade Japanese sovereign debt. They might also decide the central bank had lost its independence.

“The policy mix of fiscal stimulus and monetary expansion looks very much like monetization of government debt,” admits Ugai. His confession underscores the need to construct a convincingly worded cooperation agreement that avoids moral risk and preserves the independence of central bank monetary policy. It requires the BOJ, in our opinion, to follow a tricky and narrow path.

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