After decades of ultra loose monetary policy, an improving Japanese economy has supported a gradual monetary policy normalisation by the Bank of Japan. Policy rates stand at the highest level since 1995, and the market is pricing in more hikes under a fiscally expansive Prime Minister with a strengthened mandate after recent parliamentary elections.
However, recent pressure on the yen and the back of the JGB curve raises a key question about the appropriate mix of monetary and fiscal policy: will the BoJ pivot towards a more aggressive normalisation path, or will a combination of politics and market reaction limit government spending in a country where debt-to-GDP easily exceeds 200%?
We address this question by looking at the following factors:
- Japan’s remaining fiscal space;
- the case for domestically-oriented fiscal stimulus;
- how the BoJ could adjust its policy path going forward;
- and the risks that could prompt market re-pricing.
More than First Blush
Prime Minister Takaichi campaigned under a banner of active fiscal policy—a mandate strengthened by early February’s parliamentary elections—suggesting there is little intention to change the country’s fiscally-dominant course. That said, the starting point for additional Japanese fiscal stimulus may be more favourable than perceived at first blush due to the following factors:
- Although the level of Japanese debt-to-GDP is much higher relative to developed market peers, it has been falling in recent years in contrast to other major economies (Exhibit 1).1
Exhibit 1
After climbing for decades, Japan’s debt-to-GDP recently turned lower
- Tax receipts have surprised on the upside as a consequence of solid nominal GDP. Moreover, Japan’s fiscal outlook, as estimated by the IMF, compares favourably and looks relatively restrained when compared against the oft-cited 3% benchmark (Exhibit 2).
Exhibit 2
Japan’s fiscal deficits appear relatively tame compared to its DM peers
- A scenario where anticipation of rising fiscal spending leads to sequential expectations for higher interest rates, larger balance sheet losses requiring fiscal support, and, hence, worsening fiscal conditions appears unlikely in Japan. While a similar scenario unfolded during the UK’s 2022 mini-budget fiasco, the BoJ prepared for its normalisation process by building up buffers via retained profits since 2015.
Furthermore, after more than 10 years of supply-side reforms under Abenomics and given the U.S.-initiated hurdles to Japan’s export-led growth model, there may be credence for a policy pivot to domestic demand stimulus.2 Japan compares favourably on supply side metrics, such as labour market participation (e.g., female labour participation in Japan is now higher than that in the U.S.) as well as private investment and productivity, suggesting that public investment and targeted support for households could help underpin momentum for domestically-generated growth.
That said, we expect potential market feedback to keep the PM on a narrow path of “responsible and proactive” fiscal stimulus.
A Policy Reset
In an environment of greater fiscal expansion, a more hawkish stance from the BoJ would help mitigate risks of further yen depreciation and an unanchored increase in long-term interest rates.
The current, gradual path of BoJ policy normalisation has been predicated on a conservative fiscal backdrop. But based on the policy cadence of a 25 bp rate hike every six months, it would take two years for the policy rate to reach the middle of the BoJ’s estimated neutral range (Exhibit 3).Yet, recent volatility in long-term JGB yields and a weaker yen relay sentiment that the BoJ’s cadence may be too slow.
Exhibit 3
Global Estimates of Neutral Monetary Policy Rates
At this point, there is no obvious reason why the BoJ should be locked into a bi-annual cadence. Financial stability risks from higher rates have not materialised, and the real Japanese economy has been relatively insensitive to higher interest rates, with investment, consumer spending, and the job market demonstrating a surprising degree of resilience. If anything, the BoJ policy committee communications have recently noted that financial stability risks could develop as a consequence of financial conditions being too accommodative, rather than too tight.
That said, Japan today is not an echo of the pattern seen when the Federal Reserve and the ECB fell behind the curve as the pandemic receded. Headline inflation in Japan has consistently exceeded the 2% target, but inflation expectations are still adjusting to a 2% environment and underlying inflation measures remain below 2% (Exhibit 4).
Exhibit 4
Japan’s underlying inflation measures still remain below 2%
The BoJ expects that continued economic expansion against a tight labour market will sustainably drive a wage-price spiral to the 2% target. As a result, a somewhat faster pace of rate hikes, say every four to five months, would be an appropriate monetary policy reset against a backdrop of more expansive fiscal conditions. However, the macro picture does not signal that the central bank is so far behind the curve that sequential rate hikes or increases in increments larger than 25 bps is currently warranted.
Base case: A Benign Realignment of the Policy Mix
Our base case is that fragmented politics and financial markets provide guardrails that keep the PM on a narrow path of “responsible and proactive fiscal” policies, assuming the macro backdrop remains favourable. For its part, the BoJ should maintain its gradual policy normalisation, but at a somewhat faster pace when it comes to rate hikes.
Therefore, we see some of the recent market moves as an overreaction to the fiscal headlines and believe that above-target inflation is not currently signalling that the BoJ is behind the curve. However, market pricing will likely remain volatile as the BoJ balance sheet continues to contract against rising issuance (Exhibit 5), placing a greater emphasis on other market participants. The pressure on price discovery is of course magnified in a world of even higher issuance. In that sense, the timing of the policy adjustment may be less than ideal and points to potential risks regarding the potential for further market volatility.
Exhibit 5
The BoJ’s holdings of JGBs declines as issuance increases further
Repricing Risks
Our benign base case is flanked by plausible risks that that could trigger a market repricing, including:
- A BoJ reassessment of the macro outlook, including any revision or sign that the top of its estimated range for the neutral policy rate has been revised higher, due to AI-related productivity gains, for example.
- Signs that central bank independence is being undermined, including messaging from the PM regarding displeasure with higher interest rates and/or the appointment of a politically-motivated arch dove to the monetary policy committee.
- External factors, such as an overheating U.S. economy, that triggers a weaker yen. Such a scenario would magnify the Japanese fiscal and monetary policy mismatch and warrant higher interest rates and/or verbal interventions, such as those in recent weeks over concerns regarding yen depreciation.
- Volatile price discovery that feeds into financial market disorder, creating temporary liquidity issues that requires the BoJ to step in as lender of last resort.
A Benign Realignment
In summary, we see scope for fiscal expansion targeted towards bolstering Japan’s domestic demand. Whilst our assessment is that the BoJ is not currently behind the curve, some realignment of monetary policy is likely necessary, just as the BoJ’s footprint in the JGB market recedes. This will require new participants to step in, adding stress to the price discovery mechanism.
Therefore, our assessment is that even in a benign scenario, we should expect continued financial market volatility. For such volatility to tip into disorder, we identify three warnings: a sharp reassessment of the Japan macro outlook, undermining of central bank independence, and an overheating U.S. economy.
1 Exhibit 1 shows general government debt. Net debt is lower given the assets owned by the Japanese government.
2 Abenomics refers to the economic policies promoted by former Japanese Prime Minister Shinzo Abe. The policies include “three arrows” of monetary policy easing, flexible fiscal policy, and structural reforms.
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