BoJ’s Hesitation in Policy Normalisation Due to Medium Level Inflation

BoJ’s Hesitation in Policy Normalisation Due to Medium Level Inflation

Speculation has been circulating in the market that the Bank of Japan (BoJ) is considering withdrawing its negative policy rate in the near future. This speculation has led to a decrease in the dollar-yen exchange rate. However, the BoJ has been hesitant to make any policy changes, particularly in terms of tightening its stance.

The BoJ’s previous adjustment of yield curve control (YCC) was done cautiously, with only the cap of the 10-year yield being raised to 1 percent while the target remained at zero percent. Even in the current round, the policy rate is expected to remain at or slightly above zero percent, indicating that the policy stance is not tightening significantly.

Japan has come a long way since its lost decades, with its economy now shifting to China. Despite the economic challenges faced by Japan in the past, it should have been able to resolve most, if not all, of its problems after two decades or five to six normal economic cycles. However, there are still doubts about whether there is strong inflation pressure in Japan.

One key factor contributing to this doubt is Japan’s ongoing population decline, which is becoming increasingly serious. Additionally, technological advancements have been generating deflationary pressures in the country. Over the past few years, while most Western countries have experienced high single-digit to double-digit inflation rates, Japan’s inflation has only peaked at 4 percent by the end of 2022. This suggests that Japan’s inflation is more influenced by local factors rather than global ones.

With inflation levels at an ideal 2 percent in Japan compared to Western countries’ persistent 3-4 percent inflation rates, there seems to be no urgent need for the BoJ to change its policies. In fact, their incentive to do so has been quite low. Another reason for their reluctance is the potential economic weakness ahead, as Japan has been experiencing consecutive quarter-over-quarter GDP contractions.

A chart depicting the relationship between broad money (M3) and core CPI (CCPI) in Japan provides further evidence of the BoJ’s hesitation. The chart shows that fast growth in broad money, which is a result of lending improvements, leads to inflation. However, the exceptional high lending growth observed between mid-2020 and mid-2021 cannot be sustained, and it has since returned to a near-normal level of 3 percent.

Based on this model, inflation is predicted to decrease going forward. Therefore, any policy tightening at this point would only intensify the potential disinflationary pressures in Japan. This explains why the BoJ has been reluctant to make any changes despite facing significant market pressure.

In conclusion, the BoJ’s hesitation in policy normalization is primarily driven by Japan’s medium level of inflation and the potential economic weakness ahead. With inflation levels at an ideal 2 percent and the country facing population decline and technological advancements generating deflationary pressures, there seems to be no immediate need for the BoJ to change its policies. Additionally, the relationship between broad money growth and inflation suggests that inflation is likely to decrease in the future, further justifying the BoJ’s reluctance to tighten its policy stance.