Bank of Japan governor Haruhiko Kuroda is probably congratulating himself after he caught the markets flat-footed last week with his surprise expansion of the quantitative easing program. Traders were less impressed, as it looks like he had been pulling the wool over their eyes with previous comments that everything was going according to plan while giving no hints any further action was required.
On October 28, Kuroda told parliament: "Japan’s economy has been on a path that suggests that the 2% price stability target will be achieved as expected."
Japanese has effectively achieved full employment, and growth has reached its full potential. Photo: Thinkstock
But three days later, the monetary policy statement announcing a boost to the QE program said: "If the current downward pressure on prices remains, there is a risk that conversion of the deflationary mindset might be delayed. To pre-empt the manifestation of such risk and maintain the improving momentum of (inflation) expectation formation, the Bank judged it appropriate to expand the quantitative and qualitative monetary easing".
Big bang effect
So it seems what Kuroda had been saying over recent times was just to throw traders off the scent, so the BoJ would get a bigger bang for its buck when announcing expanded QE. He certainly got this “bang” in the currency and stock markets. But he might have been too clever by half: what the markets giveth, the markets can taketh away. The BoJ has now gone “all in” with its bond buying and, as this chart on its dominance of the bond market shows, is on course to own more than half of the total amount of government securities on issue. Japan is the second largest bond market in the world. 
The vote in favour of last week’s announcement was tight: 5 to 4 of the BoJ board was in favour. What tipped the balance was the risk that all the hard work of turning a “deflationary mindset” into a “virtuous cycle” would be undermined by the drop in commodity prices, especially oil (down 17% in yen terms over the past two months). Such price declines could reinforce in the Japanese psyche the expectation that deflation was the natural course of events. The virtuous cycle that the BoJ claims is at risk starts with what seems is a trend rise in employee incomes, leading to increased consumer spending, a positive output gap and rising inflation expectations. 
The output gap represents what the economy is capable of producing if the available labour and capital resources are fully employed. Japan’s unemployment rate is down to 3.50% – effectively full employment – so the “labour input gap” has closed and therefore the trend of increasing employee incomes can be expected to continue. The economy is now growing at its potential, as shown in this output gap chart.
So if the “virtuous cycle” can be maintained, actual inflation will rise and inflation expectations will settle around the target level of 2%. Inflation expectations are the target of the BoJ’s monetary policy.
Where does this leave the exchange rate? It’s notable that in speeches from BoJ board members and the monthly monetary policy statements, the currency hardly gets a mention. The minutes of the monetary policy meeting held on October 6 to 7 said that the depreciation of the yen was having positive effects on the whole, via a rise in corporate profits and an increase in consumption due to the wealth effects of a rally in the stock market. Also, a prolonged depreciation of the currency would restrain the pace at which Japanese manufacturers shifted production offshore and therefore increase domestic business fixed investment.
On the other hand, the rise in import prices caused by the falling exchange rate is having a negative impact on the terms of trade, which is effectively a decline in national income.
So a mixed bag. Certainly, the BoJ is not engaging in a “currency war”. A lower exchange rate is a side-effect, not a target, of monetary policy. The decline in the yen over the last couple of years sees it closing in on the levels last seen in the early 1980s during Japan’s “economic miracle” period (click chart below to enlarge). And yet still inflation is at rock-bottom levels – something those urging the European Central Bank to target the exchange rate should note.
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