Bank of Japan Goes "All In" To Stem Deflation

In an attempt to fight off worsening deflation and prevent the economy from falling into another recession, the Bank of Japan (BoJ) announced its largest foray yet into the realm of quantitative easing (QE). It lowered its benchmark interest rate to between zero and 0.1% (effectively 0%), set up a ¥5 trillion ($59.7 billion) fund to purchase government and corporate bonds, and also created a ¥30 trillion lending facility using those assets as collateral. The breadth of such QE measures caught the market off-guard and dispelled most concerns about the BoJ being too timid in the face of another economic downturn. And yet, even though the BoJ seems to be placing its largest wager ever on the table, we cannot help but ask: Is it enough?

By enough, we wonder whether QE alone is the answer. Japan is no stranger to these operations - its last QE program was implemented midway through the 2000-03 recession and lasted for over four years. But its intention - to flood the market with more than ample liquidity - is limited by the amount of demand in the market. Strictly from a financial perspective, lending conditions are ideal. Money is all but free to borrow, banks have plenty of access to funds and the labor market is as loose as it has been in a generation. But weak demand indicators suggest a poor outlook going forward, offering businesses little incentive to do anything more than save those yen for another day. All the QE in the world will not change that situation.

In Tokyo, hints are coming out about a $55 billion (1.1% of GDP) stimulus package being discussed, supposedly to be paid for through unexpected tax revenues accumulated through the first six months of the April-March fiscal year. Depending on how this stimulus is targeted, it could provide enough of a gain to stem off another prolonged recession. Incentives to private consumption - the laggard of the GDP accounts - could provide some benefit and raise confidence, but it would hardly be a fix for flagging demand.

The government and the BoJ have been trying to stimulate exports by intervening to drive down the yen, but like other measures this only provides artificial relief while doing little to get the economy back on a self-sustaining growth track. Even if the Bank wages an extended currency intervention campaign similar to that in 2003-04, it will only offer a brief respite before the country's longstanding imbalances force the yen higher.

The only cure for what is ailing the Japanese economy is a good dose of inflation, which is hard to come by when the globe is concerned about deflation. Even with interest rates as low as possible, real interest rates are at five-year highs, giving strong incentive for foreign investors to flock to the yen and drive its exchange rate ever-higher under the assumption of continued deflation. A burst of higher prices could break that cycle, and the sooner the better as far as the Japanese economy is concerned.

But creating inflation is easier said than done when it comes to Japan. Ultra-loose monetary policy has failed to spur price pressures, and heavy deficit spending has only generated temporary growth and a lasting mountain of debt. The usual vehicles for heating up the economy are no longer adequate, leaving policymakers with the daunting challenge of heating up an economy that refuses to thaw. Creative and possibly counterintuitive policies are required - incentives to encourage spending but not saving, and to rekindle domestic demand in a sustainable manner. Most of the countries throughout the industrialized world are pondering this riddle for their own recoveries, but considering the dire state of the Japanese economy, Tokyo is the one most in need of a solution.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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Second Vice President