Written by Michael Metcalfe, Head of Macro Strategy, State Street Global Markets
Writing ahead of the September BoJ gathering in 2022, we argued in Time for Japan to act (first edition!) that the authorities should begin monetary tightening both through moving the cap on JGB yields and FX intervention.
But while both were eventually forthcoming, it is somewhat sobering to note that we are writing a close to identical piece a year later, ahead of this September’s BoJ meeting. Japan’s economic backdrop is, if anything, stronger. Growth is certainly stronger than expected, inflation has persisted and is flowing through into both wage growth and expectations.
Long-term rates have now been allowed to drift higher in two tweaks to yield curve control, but short-term rates remain negative and bigger rate increases elsewhere mean the JPY is even more undervalued today than it was a year ago. And with energy prices rising once again, this is even more problematic than it was then. The reality is that inflation has returned to Japan.
This was something of a speculative claim last year. After another year of inflation it is less so today. Japan’s still highly accommodative monetary policy settings, including a wildly undervalued currency, are increasingly out of line with this reality. Admittedly it still feels somewhat churlish to write that the Japanese authorities need to act soon to prevent too high an inflation rate, but that is increasingly the reality.
This means we stick with our premise that every BoJ meeting should be considered a live market event. With the partial success of the most recent measures to widen the JGB yield range, an eventual move out of ZIRP seems to be the next logical step. And in a similar vein to this piece last year, intervention to prevent a further destabilising depreciation in the JPY would further help consolidate the required tightening in monetary conditions.
Still getting better
Dating the beginning of the monetary tightening cycle as Japan’s considerable FX intervention almost a year ago, the economic news since has been encouraging. Growth projections are in line or better than a year ago (Figure 1) and are not far behind the US, where the strong growth story gets far more attention.
The change in consensus estimates of Japan’s inflation is even more notable. Last September inflation was running at 3%, but was projected at 1.4% in 2023 and 0.8% in 2024. Today the latest inflation annual inflation print is a little stronger at 3.3%, but the forecast for this year has now more than doubled to 3% in 2023 and 1.9% in 2024. What was originally forecast as another temporary jump in inflation has morphed into something different.
We could quibble that the 2024 projection is still below 2%, and in fact the BoJ’s projection for 2025 is even lower at 1.6%. But there is no denying that the case for monetary tightening, or at the very least less loose policy, is much more compelling today than a year ago. Even though this process is underway with the amendments to yield curve control, 10-year yields are still deeply negative in real-terms and short-term rates negative in nominal ones. The descriptor ultra-accommodative monetary policy still appears to apply. This is especially the case if we also factor in the JPY.
Still way too cheap Although the JPY briefly strengthened after the BoJ began loosening yield curve control, this strength proved short-lived as yield differentials continued to move against the currency. Benchmarked to relative prices from goods level PPP-series from PriceStats, the result is that the JPY still remains ridiculously undervalued. It is 46% cheaper than where a basket of identically matched goods across the US and Japan would put the exchange rate.
While a weaker JPY can be a helpful boost for exports, with forecasts for inflation already close target it is less welcome from the perspective of inflation. The prices of imported goods have risen dramatically in the past two years and, even though the annual rate has subsided sharply, it will soon reaccelerate thanks to base effects and higher energy prices.
Time to act again
Against a backdrop of the need to tighten monetary conditions more generally, a weak JPY has become more of a hinderance than a help and the rationale to at least stop further JPY weakness is growing once again. Last year we drew Figure 5 noting that the pace of JPY weakness over the prior six months had been even greater than that seen during the prior period of aggressive official JPY buying.
Assuming that Japanese authorities repeat their bout of JPY buying this week the pattern looks very similar. The main difference today is that Japanese fundamentals, growth and inflation, are more robust, making the case for intervention arguably even stronger.
One hesitation from the experience of both last year and the 1997/98 period is that intervention did not immediately reverse JPY weakness. In 2022 that ultimately required the tweak to yield curve control and in 1997/98 intervention from the Fed also. But in both cases the counterfactual – what if JPY buying did not occur? – is difficult to ascertain.
JPY weakness could easily have overshot. In part that is what is still happening today. If the BoJ, as most expect, keep rates on hold this week, USDJPY could easily overshoot beyond 150; taking its undervaluation back to more than 50%. This would be an unwelcome development. Of all the recent comments from officials in the past month, perhaps the most telling came from US Treasury secretary Janet Yellen, who noted that JPY intervention would be understandable to smooth out the volatility in the currency. As we noted a year ago, it is once again time for the BoJ and the MOF to act.