16 January 2018
The Japanese economy has survived both economic and natural disasters in recent decades, with its political and economic institutions proving remarkably resilient. How would it fare then in the event of an inflation-induced shock that triggered both dollar strength and market dislocation? In addition, is its growth model threatened by a populist-inspired attack on the international economic and geopolitical order? Let us first deal with the prospect of an inflationary shock. Based on market and survey data, inflation expectations remain subdued despite core inflation rising in recent months (see Chart 8). This is remarkable given the extent of the monetary support thrown at the economy in recent years. To date, speculation that the Bank of Japan would remove its emergency policy setting in the near future has largely rested on political considerations. Few observers are speculating that price or growth fundamentals are such that the Bank of Japan is on track to meet and overshoot its 2% target and therefore to begin the process of policy withdrawal. If inflation were to surprise even the BoJ’s bullish price forecasts, we would expect an unfettered bond market to aggressively re-price, with implications for equity valuations too. This would present the central bank with some difficult policy choices. In practice it is likely to resist this sell-off through its yield curve control framework, arguing that it needs to see a longer-term improvement in inflation fundamentals. Beneath the surface, concerns over higher government borrowing costs will also play a role in this decision.
One key consideration for the Bank in seeking to manage the financial repercussions of a global inflation shock is how the yen would behave in such a scenario. In theory, a widening of the interest rate differentials should amplify the USD/JPY exchange rate. This is certainly plausible given that the Bank of Japan’s overshooting commitment should mean its reaction function lags other developed markets. However, the large overseas investments made by domestic investors in response to the BoJ’s aggressive QE programme has pushed Japan’s net international investment position close to a record high. Any risk-off event is likely to trigger considerable capital repatriation that could overwhelm fundamentals in the near term. That may prove problematic for Japan’s exporters and dampen growth expectations, testing the Bank’s commitment to its inflation target anew.
The prospect of a more confrontational approach from the Trump regime to international trade may prove more damaging not just for Japan but for the developed Asian region as a whole. With the administration’s sights firmly set on NAFTA, some of the discord about large bilateral trade imbalances between the US and some Asian exporter economies has died down. However, import growth remains relatively weak as domestic monetary and fiscal policies yield disappointing levels of private sector demand, while growth-enhancing structural reforms flounder. Another round of calls for domestic rebalancing would be sure to follow, but the prospect of these economies enduring difficult adjustments to their notoriously inflexible labour markets appears low without a significantly higher sense of crisis (see Chart 9). However, without the option of exporting themselves out of any subsequent economic downturn, the risk of stagnation consistent with Japan’s lost decades would return to the region.