Japan’s central bank, known as the Bank of Japan (BOJ), has been facing significant challenges in recent years. With sluggish growth and a depreciating yen, the BOJ is expected to exit its negative interest rate regime this spring. However, this move may not be enough to alleviate the depreciation pressure on the yen. In this article, we will delve into the current situation faced by the BOJ and the potential implications of their policy decisions.
BOJ Governor Kazuo Ueda is under immense pressure to stem the depreciation of the yen caused by the divergence between high U.S. interest rates and Japan’s ultra-easy policy. However, the BOJ is also constrained by high inflation rates that policymakers deem unsustainable. This contradiction is further compounded by the fact that high inflation has crimped domestic demand, leading to a technical recession. Sayuri Shirai, an economics professor at Keio University, highlights the seriousness of this challenge and dilemma faced by the BOJ.
Despite these challenges, Shirai predicts that the BOJ is likely to make some policy changes, including the removal of negative interest rates, this spring. One of the key reasons for this anticipated change is the concern over side effects. The recent weakening of the yen and the expectation of market participants regarding BOJ normalization also contribute to this likelihood. However, whether the BOJ can achieve stable inflation of 2% remains uncertain.
The chronic weakness of the yen has had repercussions on Japan’s economy. Not only has it diminished the purchasing power of consumers within the country, but it has also devalued the country’s exports. The prolonged high inflation rates, although not sustainably driven by domestic demand, have adversely affected domestic consumption. Consequently, Japan experienced a second consecutive contraction in GDP during the fourth quarter. Furthermore, while overall inflation has been gradually slowing down, “core core inflation” has consistently exceeded the BOJ’s 2% target for over a year.
During its January meeting, the BOJ unanimously decided to maintain short-term interest rates at -0.1% and stick to its yield curve control policy. This policy sets the upper limit for 10-year Japanese government bond yield at 1% as a reference. The BOJ has been cautious and diligent in its efforts to reflate an economy that has been shackled by deflationary pressures for decades. The market expects the BOJ to move away from its negative rates regime at its April policy meeting, once there is confirmation of a trend of significant wage increases resulting from the annual spring wage negotiations. The BOJ believes that higher wages would lead to increased consumer spending, thereby stimulating the economy.
Former BOJ policy board member Sayuri Shirai cautions that Japanese yen-denominated wages and household consumption are currently declining. This lack of correlation between prices, wages, and consumer demand makes it extremely challenging for the BOJ to pursue normalization. Additionally, the interest rate differential between Japan and other countries creates significant depreciation pressure on the yen. Consequently, the BOJ faces difficulties in raising interest rates, even if it were to do so in small increments. The weakened state of the economy also restricts the BOJ’s ability to implement continuous interest rate hikes.
The Bank of Japan is confronted with a delicate balancing act as it navigates through the challenges of sluggish growth, high inflation rates, and a depreciating yen. While an exit from the negative interest rate regime is expected this spring, it is unlikely to completely alleviate the depreciation pressure on the yen. The BOJ continues to grapple with the dilemma of sustaining inflation without further dampening domestic demand. As Japan’s economy stands at a critical juncture, it remains to be seen how the BOJ’s policy decisions will shape the future.
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