Will yen rout make BoJ budge?

Japan’s headline consumer price inflation (CPI) index has climbed above the 2% target for the first time in seven years. While higher food and energy prices have been the dominant driver, with core elements remaining subdued, there is evidence of a broadening of price pressures. Around 70% of the CPI basket is higher than a year earlier, the joint-largest share since 2001. And inflation expectations have climbed to a 14-year high, paving the way for continued price rises.

But one obstacle is Japan’s entrenched deflationary mindset, which has meant measures of underlying inflation remain muted. Earlier this month, Governor of the Bank of Japan (BoJ) Haruhiko Kuroda had to apologise for suggesting households were becoming more accepting of price rises.

Surveys suggest these price sensitivities are beginning to soften, although this may partially be due to “forced” savings accumulated during the pandemic. These were estimated to have stood at ¥50 trillion ($376 billion) at the end of 2021 by the Bank of Japan. To ensure a permanent shift takes place, one final piece of the puzzle needs to fall into place: higher pay growth. 

Could Japan see a virtuous circle of inflation?

Whilst real wages in countries in the Organisation for Economic Co-operation and Development (OECD) have risen 36% since 2000, they have stagnated in Japan. This remained the case at this year’s shuntō (spring wage offensive), with pay deals rising 2.3% despite the labour market tightening.

But the yen’s sharp depreciation could be a catalyst for change. On a trade-weighted basis, it has lost over 10% of its value this year. Firms will struggle to absorb higher import prices, particularly alongside increased energy costs. Export competitiveness will also be boosted, leading to an expansion in output and investment. These factors could come together to create a virtuous cycle of inflation.

Outside of the main shuntō negotiations, a litmus test for wage growth will be hiring associated with the resumption of foreign tourism. Still, the Bank of Japan will want to keep its foot firmly on the accelerator until inflation is sustainably converging on the 2% target. Doing so will maintain downward pressure on the yen, particularly as the European Central Bank (ECB) prepares to exit negative rates. The yen weakness has become a contentious issue ahead of next month’s upper house election. Still, Prime Minister Fumio Kishida has stressed that monetary policy and exchange rates should be dealt with separately.

Will the BoJ move to support the yen?

So far, efforts to arrest the slide in the yen have been limited to verbal interventions. A rare joint statement from the government and the Bank of Japan expressed concern about “recent currency market moves”. But this has failed to stem selling pressure, with the yen now closing in on 140 to the US dollar. This has fuelled speculation that Japan will choose to tap its vast $1.21 trillion arsenal of FX reserves. It last did so 24 years ago, when the Asian financial crisis triggered rapid capital outflows.

But this would only serve as a sticking plaster. In the seven months to June 1998, yen purchases of ¥4.1 trillion ($30 billion) failed to prevent the currency declining a further 15% over the period. Respite only arrived in October 1998, after Federal Reserve Chair Alan Greenspan warned the US economic outlook had weakened "measurably". In the space of a week, the yen rallied from 135 to 117 versus the US dollar. So if the authorities want to shore up the yen, they will need to consider alternatives to FX purchases alone.

But the yen will struggle to find a footing as long as the root cause remains the same. By implicitly capping 10-year Japanese government bond (JGB) yields at 0.25%, the Bank of Japan is having to swim hard against the rising tide of global rates. In recent weeks, the BoJ has had to ramp up JGB purchases to record levels and now owns half of those in circulation. Maintaining its current policy stance will entail further sizable JGB purchases, heaping further pressure on the yen in the process.

So whilst the Prime Minister has sought to separate monetary policy from the exchange rate, this stance may well have to be revisited. One option would be to broaden out the corridor in which 10-year JGB yields are permitted to trade to 50 basis points either side of zero. This could be further amplified by direct FX intervention, especially if done in concert with the US Treasury. It is not ideal to have the exchange rate steering the Bank of Japan, but there may be no other option if yen depreciation becomes too painful to bear.

A period of “overheating” would be beneficial

It may not be long before the Bank of Japan acts. Being excessively cautious risks repeating the same mistakes as other central banks, which are now having to adopt more restrictive policy stances. Its next meeting on 21 July will include updated forecasts, providing opportunity for a policy pivot.

But to overcome the stagnation that has plagued Japan over the past 30 years, it would be better to let the economy “overheat” for a period. Maintaining policy accommodation for an extended period will incur further yen depreciation, but that would be a small price to pay if it meant an end to the Lost Decades.