Economists, monetary policy experts and market commentators have been talking about the dilemma the Bank of Japan (BoJ) is facing for the past few months. As the BoJ simultaneously fights both the inflationary and deflationary pressures in the Japanese, it finds striking a balance between JPY exchange rate and Japan Government treasury bonds (JGT) yields a big challenge.
The Japanese economy has been facing a deflationary trend for more than three decades. After the global financial crisis, the trend accentuated further. In 2016, the Japanese authorities decided to trigger inflation by keeping policy rates below zero. Massive “free money” was pumped in the economy to boost economic activity by achieving a sustained inflation rate of 2%.
Consequent to the ultraloose monetary policy, the debt in Japan has swelled to 250% of GDP. It was not a major problem till the major trading partners like the US were also keeping the interest rates close to zero and following an expansionary monetary policy. However, once the US Fed started to unwind the monetary stimulus by hiking rates and tightening money supply, the yield differential between the US treasuries (UST) and JGT started to rise. This has put pressure on JPY, pushing it to the lowest level vs USD in three decades.
A weaker JPY makes Japanese imports expensive, raising a threat of runaway inflation that may force the Japanese authorities to hike the policy rates and tighten the money, pushing the economy back into deflationary abyss.
This is not the kind of situation BoJ has envisaged in its policy deliberations. They wanted a sustained 2% inflation primarily driven by improvement in growth trajectory led by rise in demand and higher wages. Instead, the specter of inflation is looming due to weakness in JPY and higher energy cost.
The BoJ faces a dilemma – whether to allow bond yields to go higher by hiking policy rates and protect JPY to check imported inflation; or protect low bond yields and counter JPY sell off through aggressive market intervention and other market and policy tools.
Allowing bond yields to go higher in tandem
with UST yields, may severely impact the fiscal balance as the interest
liabilities of the government would rise sharply. Allowing JPY to weaken
further may push the economy deep into stagflation. Continued market
intervention to protect
JPY (QE), will increase the money supply further and extend the
deflationary trend seen since 1990s.
While BoJ endeavors to resolve its dilemma, the following questions would need deeper examination.
1. Could the US Fed also face a similar situation in the next few years?
2. Does “unlimited QE” actually has limits?
3. Have developed economies already hit the wall in terms of fiscal leverage?
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