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FX COLUMN-Weak yen remains Japan's inflation anchor
August 27, 2014 / 11:31 AM / 3 years ago

FX COLUMN-Weak yen remains Japan's inflation anchor

- Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own -

By Neal Kimberley

LONDON, Aug 27 (Reuters) - Continuing and broad-based yen weakness would sit comfortably with the objectives outlined by Bank of Japan Governor Haruhiko Kuroda in his speech last week at Jackson Hole, Wyoming.

For a text of Kuroda's full remarks: here

The BOJ Governor said the mechanism for negotiating wage increases “stopped working effectively” while Japan battled deflation over the past two decades. He also said he wants to “anchor inflation expectations at 2 percent” to act as a benchmark for wage-setting.

That remains quite a task, and the central bank itself acknowledges that inflation in Japan will slow to around 1 percent in the months ahead.

To illustrate the challenge, see this comparative graphic of government bond yields, inflation and interest rates in Japan, the euro zone and Switzerland. link.reuters.com/fug72w

A weak yen, it could be argued, by encouraging imported inflation in a Japanese economy almost entirely dependent on energy imports, has been and remains a key support as the BOJ tries to break long-established deflationary expectations.

The central bank has sought to bring to an end a growth-strangling period during which Japanese consumers have put off purchases today in the belief that prices will be lower tomorrow.

Indeed, sources told Reuters on Tuesday that even though the Bank of Japan is expected to cut its economic growth forecast for this fiscal year in a semi-annual review due at the end of October, it is likely to keep its bullish inflation outlook.

The aim to cement inflationary expectations is unchanged.

But what if the BOJ succeeds?

Traders might wonder how Japan’s policymakers can square the circle between anchoring inflation expectations at 2 percent, and the current yield of 0.5 percent on the benchmark 10-year Japanese government bond.

Even at very low nominal JGB yields, Japan’s debt-servicing costs already consume a substantial chunk of tax revenues.

Debt servicing was forecast in December to consume nearly 25 percent of the country’s projected record spending of 95.88 trillion yen in fiscal 2014-15.

With 2014-15 tax revenue estimated at 50 trillion yen, that means the forecast debt service cost will eat up almost 48 percent of the expected tax take.

Unless the tax base expands exponentially, if a rise in inflation expectations did prompt higher JGB yields, Japan’s government would surely have to be very creative in order to service its debt.

That possibility hardly seems positive for the yen’s value.

Of course, if the process of keeping nominal JGB yields low were successful, even in the face of an uptick in inflation expectations to 2 percent, the holders of JGBs would be getting an increasingly negative real return on their money.

That would likely encourage investments in riskier assets, including those denominated in foreign currencies, in pursuit of higher yields, a process which may already have begun.

YEN SELLING

That must entail some degree of yen selling.

At the very least, by keeping JGB yields suppressed despite higher inflation, domestic bond holders are left poorer in real terms. That may well encourage some of the rentier class, Japan’s expanding regiments of pensioners, to seek employment.

Kuroda notes that the labour participation rate in Japan has been rising and said it was critical this remains a feature of the Japanese economy. He wants to create “a work environment favorable to women and the elderly in order to mitigate labour force shortages over time”.

A cynic might think beggaring Japan’s pensioners through rising negative real returns on their JGB holdings would certainly tick that box, pushing the elderly back into work.

It is clear from Kuroda’s Jackson Hole speech that engendering higher inflation expectations remains at the core of the central bank’s recipe for Japan to restore “its vitality and achieve sustained growth”.

It is hard not to conclude that a weak yen remains part of the BOJ’s policy prescription. (Editing by Nigel Stephenson and Hugh Lawson)

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