Author: Kazuo Ueda, University of Tokyo
Japanese asset prices have responded in a surprising way to the announcement of a policy package by Prime Minister Shinzo Abe and the Bank of Japan (BOJ) — they have gone up.
In November last year, before Japan’s election, Abe declared that he would pressure the BOJ into adopting a much more aggressive monetary policy stance than was practiced at the time. If the BOJ did not comply, he hinted, the Bank would lose its independence.
Between then and March the Nikkei 225 rose 40 per cent and the US dollar by 16 per cent against the yen. When the BOJ got a new governor, Haruhiko Kuroda, it responded to Abe’s request by offering a set of easing measures on 4 April that surprised even the market that had factored in an aggressive BOJ move. The BOJ has now set a 2 per cent inflation target, which it will try to hit in about two years by expanding base money by 100 per cent. To do so, it will aggressively buy Japanese government bonds (JGBs) and even risky assets such as exchange-traded funds (ETF) and real estate investment trusts (REITs). Following the move, the stock market went up by another 13 per cent and the yen weakened by 6 per cent against the US dollar.
The favourable response of asset prices is somewhat of a puzzle. The asset purchase program initiated under Governor Shirakawa, Kuroda’s predecessor, included purchases of JGBs, REITs and equities as well as corporate bonds and commercial papers. The market’s response to these purchases, however, was minimal. Back in 2001, under Governor Hayami, the BOJ carried out quantitative easing , and expanded base money by 60 per cent in three years. It also bought large amounts of JGBs to assist the expansion of base money and began purchasing equities in 2002. The stock market went up for a while, but deflation remained.
One major change this time is that the measures are front loaded. Kuroda announced that the Bank had taken all measures necessary to hit the 2 per cent inflation target, while previously it proceeded more hesitantly by trying to ascertain the impact of each measure taken on the economy. But a more significant factor seems to be the Bank’s willingness to take on an unprecedented amount of risk in the asset market. This willingness can be seen in a number of BOJ actions.
First, the BOJ is now going to take duration risks in the JGB market by extending the duration of the government bonds it buys from less than three years to about seven years. And, it will buy in large amounts — three-fourths of all newly issued JGBs. Prior to the decision on 4 April, the yield on three-year JGBs was around 0.1 per cent — about the same as the interest rate on excess reserves at the BOJ. It appeared that no matter how much the BOJ bought such short-dated JGBs, the effect on asset prices and the economy would be minimal. The BOJ now hopes that the operation will push medium- to long-term interest rates to lower levels and induce investors to buy riskier assets than JGBs.
Second, the BOJ is telling investors what risks they should take. Kuroda remarked that there is room for risk premiums to decline in Japan’s stock and property market; that is, stock and property prices could go higher. The BOJ is leading the way by buying more equity-linked ETFs and REITs. Kuroda also remarked that the high liquidity of the stock market would allow the BOJ to buy more ETFs in the future. Not surprisingly, the stock market has welcomed this statement.
Beyond a certain level, such a move by the BOJ could generate bubbles in the asset market. But the Bank hopes that the bubbles, once created, will start stimulating the economy — in which case they may be subsumed by real growth and cease to have their original character.
Put differently, the move is like a ‘helicopter drop’ of money, which normally requires both fiscal and monetary authorities to be involved. But this time around, the Bank hopes that wealth effects created by the bubbles will be enough to effect a helicopter drop. In addition, the government has increased spending under the ‘second arrow’ of Abenomics. The market may have sensed the consequences of Abenomics and decided to sell the yen accordingly.
But it is unclear whether current levels of the yen and the stock market can be sustained if negative shocks hit the economy. The BOJ may end up owning a large portion of the stock market and yet stock prices could stay depressed. The Bank, and through it the government, would incur a huge capital loss in such a case. If the bubbles succeed in stimulating the economy and raising inflation, the BOJ and the government will suffer from significant increases in long-term interest rates. Moreover, a helicopter drop of money could generate a sell-Japan type response in the asset market.
Without doubt the BOJ is taking huge risks with the measures announced on 4 April. This may be a necessary evil after more than a decade of deflation and economic stagnation. Hopefully, the risks will be mitigated by the adoption of effective measures to stimulate the supply side of the economy — the so-called ‘third arrow’ of Abenomics.
Kazuo Ueda is Professor of Economics, University of Tokyo.