Japan is now on its way to leaving the 2 per cent inflation standard, having been the last to join (in 2013). Accordingly, the Bank of Japan has scrubbed from its latest policy statement (end-April) all promise that the target will be met by any given time-line.
The apparent indefinite postponement could be deceptive. BoJ Governor Kuroda may simply be seeking to avoid the embarrassment of apologizing continually for a promise broken but still have every intention of fully using radical policies to meet the inflation target sooner rather than later. On balance though, central bank watchers in Tokyo reject such skepticism, some pointing to the likely early resignation of corruption-stained PM Abe or his defeat in a looming LDP leadership election.
No-one should expect though the early dawning of a sound money era for Japan. The largely false narrative which monetary officials and their watchers spin along the exit route from the 2 per cent inflation standard is inconsistent with such an outcome.
The narrative has at its core a demographic “plight.” The hypothesis is that the shrinking of Japan’s population alongside its severe aging goes along with diminished investment opportunity and a glut of savings. These bear down on the neutral rate of interest which most likely is now significantly negative. Hence even unconventional monetary policies could not “breathe in” inflation.
Yet this hypothesis of demographic-led demise of the 2 per cent inflation standard in Japan defies history and principle.
In the early 1920s, France was in the middle of a “demographic crisis” and yet that did not prevent the eruption of high inflation and a collapse of the franc. And yes, investment opportunity may indeed shrink in the aggregate inside Japan (fewer workers to furnish with capital goods – though there are offsets to consider such as labor-saving technology, new consumer markets aimed at a growing elderly population including dwellings and health care). But alongside this, Japanese savings in aggregate would tend to fall as the population declines, especially once the very elderly population drew down their capital for current spending.
Even if demographic influences on balance were to foster a larger domestic savings surplus, why would this not flow out into foreign capital markets in frictionless fashion without the emergence of risk premiums which would subject the neutral level of rates in Japan to downward pressure? France in the late 19th century and early 20th century recorded a huge savings and current account surplus with private capital exports to match (albeit that much of this was politically directed towards Russia).
The “Japan is different” claim rests on investors there having strong home bias; and that could be especially strong in today’s climate where many asset markets around the world are recording a high speculative temperature under conditions of monetary inflation. But temperatures are also high in Japan and the claim runs contrary to the huge boom in the yen carry trade during the last cycle — surely evidence that home bias can melt in a hot money environment.
Arguably, many Japanese investors do not realize the virulence of domestic monetary inflation given the extent of camouflage in goods and services markets. Two large factors have been contributing to the disguise: the continuing integration of Japan with the East/South East Asian economies (which drives down prices of many items) and the erosion of excess remuneration in big-company Japan as lifetime employment and seniority-based wage scales erode. Recently wage rates have been picking up in the unregulated labor market.
A third force behind the camouflage of inflation has been falling residential rents reflecting in part demographics but also increasing supply (especially in the Tokyo area).
In sum, the natural rhythm of prices has been so strongly downwards in Japan that even non-conventional tools of monetary inflation have not yet broken through the camouflage. They may do so at any point and it is premature for the Bank of Japan to conclude that goods and services inflation cannot rise in the “foreseeable future” towards 2 per cent or even higher.
By contrast there has been no camouflage for asset inflation.
In Japan, vivid symptoms of monetary inflation in asset markets include the huge leveraged trades in credit and term risk, whether inside or outside Japan; the following of a tech messiah who will turn all to gold based on past performance never mind the running up of colossal leverage and the purchase of US assets at sky-high prices. The biggest irrationality of all could be the continued holdings of massive portfolios of 10-year JGBs at zero yields; and the counterpart to this is a pattern of social expenditures, government spending and private savings which is surely unsustainable in the long run.
Japan’s pre-retirement generation is aware of the irrational strategies followed by the institutions to which their savings are entrusted. There is unease, and in some cases revulsion, coupled with the concerns prevalent among many already retired people in Japan. This unease stems from concerns about about the erosion of their savings ultimately by inflation — and this could make the exit from the 2 per cent standard seem like good politics to the next government.
The challenge will be to ignore the warnings of the neo-Keynesian establishment that Japan should get ready for a further episode of strong yen-induced deflation if the exit is pursued seriously. That story is upside down.
Yes, a full abandonment of the 2 per cent standard and all its trappings (including crucially the blatant manipulation of interest rates with 10-year JGB yields now pegged at near zero) would bring an appreciation of the yen. And there would be strong forces downwards on wages and prices in the tradable goods sector. But the falls there would be once and for all, and indeed future rises would be expected from an initial overshoot. That mechanism of a price plunge followed by expected rebound provides the basis for Japanese consumers to bring forward consumption and investment in these goods while available on bargain terms.
A high-priced yen would enable the Japanese to build up foreign assets at a cheap entry point in local currency terms providing a cushion against ultimate asset inflation destruction in its final phase. Positive interest rates in Japan would bring pressure on the public sector to cut wasteful spending while enticing international investors into a newly attractive investment money (the yen). That is a welcome trend as this country enters the stage of the demographic cycle where its savings could shrink and it transitions to importing capital on a net basis.
