It was very wise of Japan to move to a 2% (per year) inflation target and become more aggressive in meeting its inflation objective. “Aggressive” includes aiming to achieve 2% “at the earliest possible time, with a time horizon of about two years”. Japan will derive a net benefit from the move. Also, Japan’s move significantly changed the investing landscape, particularly for yen-denominated fixed-income investments.
Rightfully, some people will point out that Japan previously had a 1% inflation goal and badly failed in its attempt to meet this goal, in that it is currently experiencing deflation. The difference now is not just that a higher inflation objective has been set, but that the level of commitment to meeting the objective has greatly increased. The path toward the higher inflation objective and greater commitment seems to have begun about six months ago.
How It Happened
The changes were enabled by the election of the Liberal Democratic Party into power again on December 16, 2012 and the related reappointment of Shinzo Abe as Prime Minister. This is the gentleman who Abenomics is named after. The 2% inflation target and greater commitment are a part of Abenomics.
In January, Abe influenced the Bank of Japan policy board to set a 2% inflation target, versus the previous 1% inflation goal. (The change from having a “goal” to having a “target” was significant.) In February, he nominated Haruhiko Kuroda to be Governor of the Bank of Japan and two deputies to serve beneath Kuroda, all of whom he knew generally supported his economic policies. Earlier this month, Kuroda and his deputies were important in the the Bank of Japan policy board voting to, among other things, increase JGB (Japanese government bond) purchases to about 7.5 trillion yen ($76 billion) per month. Kuroda and his two deputies have three of nine board votes, and Kuroda heads the board.
Based on PPP GDP (purchasing power parity gross domestic product), the Japanese economy is only about 30% as large as the U.S. economy. 7.5 trillion yen of QE (quantitative easing) is very large amount of QE for an economy this size. By far, most of the JGBs purchased will be 1-10 year securities. The average remaining maturity of the purchases will be about seven years, which is, per the Bank of Japan, “equivalent to the average maturity of the amount outstanding of JGBs issued”.
The JGB purchases aspect of the Japanese QE program is now so large that it far exceeds the amount of new (versus rollover) borrowing the Japanese government was doing each month. The 7.5 trillion yen figure is somewhat deceptive in that the Bank of Japan is only increasing its JGB holdings by about 50 trillion yen per year, indicating an increase of about 4.2 trillion yen per month and that already held maturing securities will not be rolled over. In total, the monetary base will be increased by 60-70 trillion yen per year though, as there are other aspects to the Bank of Japan’s QE program.
Currency Devaluation Complaints
There were and are some complaints about Japan devaluing its currency. These complaints have no rational force behind them. Japan is simply moving to the same 2% inflation objective that the U.S. and some other developed countries use. We cannot tell Japan they cannot do the exact same thing we have done and are doing. If the yen ends up much weaker because of Japan’s move to a 2% inflation target, so be it. Theoretically at least, the yen will be at the value it would have been at all along if Japan had been using the same 2% inflation objective as the U.S. and some other developed countries.
Because of international concerns regarding Japan devaluing its currency, Japanese officials engage in a dance whereby they know they are devaluing their currency; but they do not say they are. They cast devaluation as a consequence of the new inflation target, which it technically is. There is no target for the value of the yen; but there is, now, a target for yen inflation.
Things That May Slow Reaching 2%
Some people think Japan will be unable to achieve 2% inflation, but this does not seem to make sense. It does not matter what conditions have led and are leading to Japan experiencing deflation. If Japan floods the market with enough yen, sufficiently revises inflation expectations, and is willing to take additional steps as necessary―as it now appears to be, inflation will occur. On the other hand, Japan may not be able to prudently achieve 2% inflation in two years. Japan may be forced to slow the pace of change.
In flooding the market with yen, the Bank of Japan may begin to create or create a dangerous asset bubble or other financial system anomaly that forces the bank to slow down. Also, if the yen devalues too much too soon, other countries may ask Japan to slow the pace of change due to the impact upon their imports and exports.
How Japan Will Benefit
There are many benefits related to Japan’s move to a 2% inflation target; however, most of these benefits are offset by something. The following benefits are not offset and are lasting. Things such as Japan’s aging population and low birth rate will continue to be issues, but they do not prevent the move to a 2% inflation target from being a good thing.
(1) Larger and Stronger Economy
Until recent years, Japan’s inflation objective was less than 1%; and Japan often experienced deflation in the last decade or two. Deflation encourages people to spend less because their money becomes worth more just sitting there. This lowers economic activity. A little inflation is often viewed as a good thing. Deflation was also bad in that it was influencing the yen to be overvalued. People were more prone to park in yen because, with deflation, the yen had an underlying advantage over other currencies which were inflating.
As Japan achieves 2% inflation, domestic spending will be influenced to increase, thereby increasing the size of the economy. Also, the yen has devalued about 20% in the last six months in anticipation of the Bank of Japan flooding the market with more yen. No one knows what level the yen will eventually trade at; but the level will be significantly lower than it would have been less the Bank of Japan’s actions, and, in reaction, Japanese exports will be higher, which will also increase the size of the economy. On a percentage basis, the domestic spending and export increases will be onetime benefits that will take some time to fully kick in; but, on a non-percentage basis, the economy will continue to be larger on an ongoing basis thereafter.
In addition, the expansion of the monetary base (i.e., the infusion of yen into the financial system) will be somewhat permanent. On an ongoing basis, funding will be easier to come by and the economy will perform better than it would have otherwise.
(2) Inflating Away of Some Existing Debt
Japan has the highest national-debt-to-GDP ratio in the world. It easily exceeds 200%. In inflating 2% per year, in real (inflation-adjusted) terms, Japan will shrink its remaining already existing debt by 2% per year. All previous yen-denominated borrowing, whether by the Japanese national government or not, will benefit from this effect; and all previous yen-denominated lending will be hurt by it. Assuming 0.5% inflation in the first year, 1.5% inflation in the second year, and 2% inflation in the years thereafter, the following table shows what will happen to the real value of yen-denominated debt. Previously, when yen were lent, it was on the assumption that inflation would be about 0-1%―not 2%. Interest rates on previously existing debt reflect this.
|Real Value of Already Existing Debt||99.50%||96.11%||92.38%||88.79%||83.67%||68.64%||56.31%|
(3) Better Monetary and Economic Decisions
Since, with a 2% inflation target, Japan will be on the same page, or closer to it, with the U.S. and some other developed countries, Japan will be able to make better monetary and economic decisions. It is easier to make good decisions when your system is more comparable to others. The other systems then serve as better examples for you.
How It Matters To Fixed-Income Investors
Assume Japan will achieve 2% inflation―if not in about two years, fairly soon thereafter. There is no known element that definitively prevents Japan from doing so. If you are a buy and hold investor, you are holding yen-denominated debt, and its yield does not reflect this inflation, sell it. If you are a buy and hold investor, you are considering buying yen-denominated debt, and its yield does not reflect this inflation, do not buy it. You do not want to be caught holding when Japanese interest rates normalize, i.e., reflect 2% inflation in the not-too-distant future.
Temporarily, the yields for JGBs do not reflect the likely 2% future inflation. The Bank of Japan’s buying of JGBs has perverted the demand side of the JGBs’ supply/demand equation. The yields for 10-year and 30-year JGBs are, actually, lower than they were 6 months ago. We have seen the same effect in the U.S. with the Federal Reserve buying a large amount of U.S. Treasuries and RMBSs (residential mortgage-backed securities) via QE. Related yields have been pushed and held down to abnormal levels. For instance, it does not make sense for 10-year U.S. Treasuries to be paying less than 2% when the U.S. inflation target is 2% and the U.S. dollar is currently inflating at near this rate.
Among other things, about 7.5 trillion yen ($76 billion) per month that would normally go toward buying JGBs will need to go someplace else. The Bank of Japan will buy this much, so others cannot. This effect was somewhat occurring in prior months, but not nearly to the extent that it is now.
Despite the fact that the yields of non-Japanese national government securities seem to have fallen some in reaction to the situation in Japan, a lot of the 7.5 trillion yen per month figures to stay within Japan, as the Bank of Japan and the Japanese government are hoping will be the case because this will aid the Japanese economy. Per the Bank of Japan, less than 10% of outstanding JGBs are foreign-held. Money from home tends to stay home. The situation in Japan should only hold down U.S. Treasury yields, and the yields of other non-Japanese national government securities, to a limited degree. U.S. Treasury yields are still very likely to increase going forward, but the increase will be slightly dampened.