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Forex: Delivering in Japan

There’s no doubting that the Bank of Japan delivered over and above what was expected. But the two questions to explore are will the policy announcements be enough to deliver 2% inflation on their imposed 2 year horizon and what will be the impact on the currency?

On the inflation ambition, it’s a tall order and there are two elements to the answer. The first is the transmission mechanism, the second is the reaction of the different sectors of the economy (firms, households, government). On the transmission mechanism, Japan has spent much of the past near twenty years pushing on a string with regards to monetary policy. Japan was the early ‘modern’ example of a balance sheet recession, one concentrated in the corporate sector (vs. the household sector of the US in the run-up to 2008). So as much as the Bank of Japan was cutting rates and pushing money (the monetary base increased 50% 2001-03), the corporate sector was choosing to pay-down debt.

From a balance sheet perspective, the omens are better this time around, although this must be set against the backdrop of all central banks suffering from a weakened transmission mechanism at the zero lower bound. It’s all relative and far harder vs. a positive nominal rate regime. This is where we fall into the reaction side. Deflation has a crippling impact on all 3 sectors of the economy. Households don’t purchase today what they believe they can buy tomorrow at a lower price. Firms are discouraged from investing (and increasing wages) and governments see an ever rising real debt burden.

There have been signs of change in the corporate sector after a period in which contractual cash wages have fallen 7% over the past 10 years. Some firms have been increasing wages, although many of the bigger ones have increased bonuses, rather than increase their cost base via wage increases. Indeed, over the past 4 years, the bonus element of earnings has risen 13.5%, reflecting this caution.

But it could well be fiscal policy and the actions of the government that determine whether the inflation target is achieved. Japan has been beset by periods where recovery has been choked-off by premature fiscal tightening. Such a move could well end up reversing any positive signs that emerge in the first year so the new administration needs to avoid the temptation of choking off any signs of a much-awaited sea change in the economy.

So for now, it’s a tall order to expect the 2% inflation target to be achieved. The best hope is that we see signs of an end to the deflationary mind-set that has gripped the economy. For the yen, we’re likely to see further weakness, but the pace of depreciation is unlikely to match that of recent months. The 100 level on USDJPY may well have to wait until later in the year.

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