In a stunning blow to central bank independence, the Bank of Japan seriously bumbled its January 18 policy decision. After setting up the markets for the second installment of a “normalization-focused” monetary tightening, the BOJ buckled under political pressure and passed — electing, instead, to keep its policy rate unchanged at 0.25%. While this may end up being nothing more than a painful detour on the road to normalization, the incident speaks volumes about the Old Guard political dominance of Japan’s deeply entrenched LDP ruling party. It is a major credibility blow, with potentially lasting damage to the New-Economy image of a revitalized post-deflation Japanese economy.
Why the Bank of Japan’s error was political, not economic
Ironically, it’s not as if the BOJ did the wrong thing insofar as the policy decision itself was concerned. After all, the Japanese monetary authorities have established a 0 to 2% reference range for CPI-based inflation, and the latest reading on inflation is only fractionally in positive territory at +0.1% y-o-y. Moreover, as our Japan team points out, there is a very good chance that Japan’s so-called core CPI (excluding fresh foods) could dip back slightly into negative territory in March. Consequently, in light of the recent shakiness of private consumption demand, which raises understandable concerns about the sustainability of the Japanese recovery, there is good reason to question the wisdom of what could have well turned out to be a premature move on the road to policy normalization. It may well be that a glacial pace of monetary policy normalization is the correct choice for a still very fragile post-deflationary Japanese economy.
The problem is that BOJ Governor Toshihiko Fukui had been direct and adamant for quite some time in offering his own take on policy wisdom – in effect, leaving the distinct impression that a rate hike was all but inevitable in January. At the same time, the ruling LDP leadership has been equally explicit in warning against a premature hike – fearing the risk of a deflationary relapse. In our judgment, and in the eyes of most market participants, the politically-independent central bank should prevail in any such dispute. Obviously, we were wrong in assessing the outcome of this power struggle. The weakening of the yen and the Japanese government bond market in the immediate aftermath of the BOJ decision tells us we were hardly alone in our mis-impression. Sadly, Governor Fukui’s flinch says it all – BOJ independence can now be drawn into serious question.
While the BOJ may have made the correct decision from a policy-targeting perspective, it made a communications blunder of epic proportions. By setting up the markets for a tightening that never happened, there could well be lasting damage to perceptions of the credibility and independence of the Japanese central bank.
Japan’s approach at odds with modern central banking
This sad incident runs very much against the grain of the current approach to central banking — a transparent and increasingly rules-based policy path that doesn’t disappoint the markets. Perfected by the Greenspan Fed and emulated with increasing success by the ECB, such policy discipline is now viewed as one of the most essential ingredients of stable and well-contained inflationary expectations – the ultimate goal of the modern-day monetary authority. The January 11 policy surprise action by the Bank of England – an unexpected 25 bp rate hike aimed explicitly at managing inflationary risks – is but the latest example of rules-based policy discipline. Relative to the Fed, the ECB, and the Bank of England, the BOJ now looks weak and politically compromised. Sure, the BOJ can attempt to rectify this image problem by moving in February after the next round of GDP data have been released. But in my view, the damage has been done. Financial market participants have long memories. Expressions of BOJ policy intent will long suffer from the credibility fiasco of January 18. Trust in Japan’s central bank has been all but shattered.
The consequences of the Bank of Japan’s interest rate decision
The consequences go well beyond the BOJ’s image problem. With Japanese short-term interest rates remaining near rock-bottom lows and now expected to do so for longer than previously thought, there’s little to stop a continuation of the so-called yen carry trade – borrowing cheaply in Japan and reinvesting in higher-yielding assets nearly anywhere else in the world. With the steepness of the Japanese yield curve likely to remain an important source of excess global liquidity, this can only perpetuate the increasingly worrisome bubbles in risky assets, such as corporate credit and emerging-market debt. Moreover, once again, the yen is headed the “wrong way” for a Japanese economy in recovery. This paints the yen into the corner as perhaps the most mis-priced major currency in the world today – underscoring the potential for wrenching adjustments in foreign exchange markets as well as the possibility of an escalation of external political pressure on Japanese currency policy.
In the end, there may well be an even deeper meaning to all of this. This incident has as much to say about the heavy-handed role of the Japanese government as it does about the BOJ. The central bank’s capitulation underscores the long-standing dominance of a one-party political system in shaping the character of the Japanese economy. Under the Koizumi government, that character seemed increasingly enlightened. There was a renewed sense of hope that the reformers were both willing and able to undertake the heavy lifting that a new and modernized economy required.
Is Japan lapsing back into its old ways?
Under the new Abe government, that perception can now be drawn into question – not just by the political pressure brought to bear on the BOJ but also by increasingly disappointing progress on financial sector reforms. A Japan that lapses back into its old ways is an unmistakable triumph for the Old Guard. That could also prove to be a huge disappointment for Asia and for the broader global economy.
I am far from a BOJ watcher. My colleague Takehiro Sato is the best in the business, in my view. My reactions above are those of an outsider looking in – attempting to put the incident of January 18 into the context of the broader monetary policy debate that plays such an important role in shaping the global economy and world financial markets. Our Japan team does not share some of the conclusions above. Robert Feldman, in particular, rejects the notion that this is a painful relapse into the days of “Old Guard dominance” – although he concedes that there has been a damaging blow to BOJ credibility (see his dispatch in today’s Forum). For me, the jury is out on the implications of this stunning development. Time will tell if the BOJ and the LDP leadership will be able to repair the damage.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum