Special

Article 22023 Will Be a CriticalYear for the BOJ

By Nobuyasu Atago

Conceptual Definition of Price Stability
At the August 2022 Jackson Hole Economic Symposium, an
economic policy symposium hosted by the Federal Reserve Bank ofKansas City, Federal Reserve Chairman Jerome Powell made an
extremely important point. Quoting former Fed Chairman Alan
Greenspan from 1989, he once again explained the conceptual
definition of the price stability that is the central bank’s objective.
Price stability, he said, “Means that expected changes in the average
price level are small enough and gradual enough that they do notmaterially enter business and household financial decisions.” This
showed that he had a strong sense of crisis regarding the risk
currently being faced.
The Bank of Japan (BOJ) has in fact expressed a conceptual
definition of price stability many times in the past. Specifically, thiswas in October 2000 immediately after the zero interest rate policy
was lifted, in March 2006 when quantitative easing was lifted, and in
January 2013 when the 2% “price stability target” was implemented.
Those explanations were consistent. The BOJ said that price stability
is “A state where various economic agents including households andfirms may make decisions regarding such economic activities asconsumption and investments without being concerned about thefluctuations in the general price level.” This is basically the same as
the explanation given by Greenspan.
The reason this definition is important is that in both Japan andthe United States price stability is stipulated by law as the central
bank’s objective. In other words, the ultimate objective of both theFed’s and the BOJ’s monetary policy is price stability, not a 2% pricetarget. The figure of 2% is nothing more than an intermediate target
toward realizing the final objective. Therefore, being fixated onachieving 2% while losing sight of the final objective is putting thecart before the horse. Unfortunately, however, the central banks ofboth Japan and the US have fallen completely into this situation.

Fed Falling “Behind the Curve”
Since the summer of 2022, the US has been experiencing its
highest inflation in 40 years. The effect of the coronavirus pandemic
restricted supplies through both labor shortages and difficulty inparts procurement, and in addition there is no question that the morethan $6 trillion in economic measures carried out by the Donald
Trump and Joe Biden administrations had an effect as well. But that
42 Japan SPOTLIGHT • January / February 2023

Author Nobuyasu Atago

is not all. The US consumer price index (excluding food and energy)rose more than 3% year-on-year in April 2021, and despite the factthat the rate of increase rose above 4% from early 2022, the Fed did
not begin raising interest rates until March 2022. At the time, Powell
admitted at a press conference to having fallen behind the curve,
noting that if they had been aware of the supply blockages and theireffect on inflation they would have moved earlier.
How did the Fed fall behind the curve? In fact, it had been aiming
to maintain a 2% price target, which it had not achieved for sometime after the 2008 global financial crisis, and under the average
price target strategy adopted in August 2020 the policy was left inplace for some time even after the inflation rate surpassed 2%. This
backfired. For the Fed, which fell behind the curve in raising interest
rates and permitted high inflation, keeping inflation in check is its toppriority, rather than overall economic conditions. Therefore, it has
been raising rates since March 2022 at an unprecedented pace,despite the risk of falling into a recession.

Price Stability Has Also Collapsed in Japan
Price stability has collapsed in Japan as well (Chart 1). The rise in
the consumer price index (CPI) hit the 3% year-on-year level inAugust 2022. Excluding the consumption tax effect, this was thehighest increase in 31 years – since August 1991. The level for
October is likely to have risen to the mid-3% range. With wage
increases remaining sluggish, continued inflation above 3% could
inflict significant damage on consumption in Japan. Chart 1 shows
the CPI for basic expenditure items derived by reclassifying the CPI
components. This index, which includes many daily necessities forwhich prices are less affected by demand, shows the rate of increase
to be in the mid-4% range year on year, meaning inflation as actually
being felt by people is much higher than 3%.
Many Japanese people are already feeling the burden of current
inflation. Chart 2 shows the results of the BOJ’s Opinion Survey on
the General Public’s Views and Behavior. The blue line shows thepercentage of people, among those who replied compared with one
year ago, who think prices “Have gone up significantly” or “Havegone up slightly” and who viewed price increases as “Rather
unfavorable”, and this figure has recently increased significantly. The
red line and the dotted line show the “Future developments in prices”
and “An increase or decrease in my household’s income”, which areparticularly major factors to be considered when making spending
https://www.jef.or.jp/journal/

CHART 1

Japan’s Consumer Price Index

Unmoving BOJ

Nevertheless, the BOJ has shown absolutely
no signs of moving (at least as of the writing of
this article in late October). If anything, BOJ
Consumer prices (all items)
September
5
Governor Haruhiko Kuroda’s explanation has
Basic expenditure items
2022
4.5%
4
been that recent inflation is a temporary result of
supply constraints, and that it is important to be
September
3
tenacious in maintaining easing. This assertion
2022
3.0%
2
closely resembles Powell’s in 2021 when the
Fed fell behind the curve, but Kuroda appears to1
believe that wages will not rise sufficiently
0
unless Japan emerges from low growth, andseems confident that against that backdrop-1
current inflation will not continue for an-2
extended period. In addition, the US and-3
European countries are beginning to move
11
12
13
14
15
16
17
18
19
20
21
22
toward normalization even as the risk of falling(Year)
into recession is increasing, but in the event
Japan was to do the same and that caused an
Note: 2014 is adjusted for the consumption tax.
Source: Ministry of Internal Affairs and Communications
economic downturn, there is no question that
Kuroda would bear the brunt of the criticism.
CHART 2The important point is a secondary ripple
Opinion Survey on the General Public’s Views
from an upturn in wage increases and inflation& Behavior
expectations. At the aforementioned Jackson
Hole symposium, Powell affirmed that whether(%)
90
Septemberinflation is caused by increased demand orAmong those who replied that prices have gone up, those who
2022
supply constraints, this does not reduce the80viewed the price increases as “Rather unfavorable” as a
78.9%
percentage of all respondents
Fed’s responsibility for price stability. Underlying
September
70
this statement is a caution against a secondary
2022
65.4%
60
ripple from an upturn in wage increases and
Septemberinflation expectations. If this were to occur, the50
2022
inflation that the Japanese people are already53.2%
40
struggling with would be increasingly prolonged.
On the other hand, Kuroda expects a
30
Major factor(s) to be considered when making spending decisions
secondaryripple. His best-case scenario is thatfor the year ahead (multiple answers allowed)
20
as the coronavirus pandemic is eventually
An increase or decrease in my household’s income
brought under control, the economy will
10
Future developments in prices
normalize and this will bring about an0
improvement in corporate earnings, which in
13
14
15
16
17
18
19
20
21
22
turn will lead to a recovery in the balance(Year)
between wages and higher inflation rates. It
Source: BOJ
would be ideal if the 2% price stability target
were then achieved, but that would be a miracle.
decisions. “Future developments in prices” has overtaken “An
Kuroda’s thinking that a certain degree of wage increases would
increase or decrease in my household’s income” since the June
eventually lead to inflation falling below 2% is realistic. And the risk
2022 survey. In terms of the aforementioned conceptual definition ofof recession in the US and Europe is increasing. There is currently no
price stability, the Japanese people are clearly disturbed by pricerational reason for Kuroda to move toward normalization, and people
level movements.
are being forced to endure high inflation while seeing the BOJ’s
inaction.
6(Year-on-year; %)Japan SPOTLIGHT • January / February 2023

43

Diminishing Market Function
Market distortions are also increasing significantly as a result of
Kuroda’s stubborn refusal to act. Currently, the BOJ’s yield curve
control (YCC: officially “Quantitative and Qualitative Monetary Easing
with Yield Curve Control”) means that a negative 0.1% interest rate
is being applied to a portion of financial institutions’ current accountdeposits at the BOJ, while at the same time the guidance target for
10-year rates is “approximately zero”. If the BOJ were to be strict incontrolling the 10-year yield at 0%, however, the side effect of lessliquidity for Japanese government bonds (JGBs) would increase, so
the BOJ is tolerating 10-year yield fluctuations within a band of-0.25% to +0.25%.
Against this backdrop, US long-term interest rates, factoring in
Fed rate increases, began rising sharply from March 2022, and thisled to a stronger trend of Japanese 10-year yields rising as well. As aresult, the upper level of 0.25% was exceeded in late March, and the
BOJ was forced to use “fixed-rate purchase operations forconsecutive days”, in which it purchased an unlimited amount of
JGBs at a designated rate to bring the yield below 0.25%. In addition,
it is not only 10-year yields that rise along with US long-term interest
rates. This put upward pressure on the entire yield curve, from shortand medium-term maturities to ultra-long-term maturities. Despite
this, the BOJ continues to force only the 10-year yield lower, and as
a result major distortions have emerged in the Japanese yield curve(Chart 3).
In mid-June, 7- to 9-year yields rose above 10-year yields, so the
BOJ added 7-year JGBs, which are deliverable issues for futures(cheapest issues) to the scope of its fixed-rate purchase operations
for consecutive days. This, however, invited greater market distortionand disruption. With liquidity for newly issued 10-year JGBs having
become extremely low, there was then a huge drop in liquidity for
7-year JGBs, making it difficult to procure cash bonds for arbitragetransactions with futures. As a result, JGBs needed to settle futurestransactions could not be procured, and many deliveries failed(settlement was not completed). In addition, because of the large
divergence between futures prices and cash prices, futures’ hedging
function diminished. It became particularly difficult to use futures tohedge ultra-long-term cash JGBs, and this had an adverse effect on
bidding and transactions for ultra-long-term JGBs. This distortion in
the yield curve continues today, making the bond market quite
vulnerable as yields in ultra-long maturities are easily prone to rise.

Continuing Yen Weakness

While long-term interest rates in the US are rising sharply as theyfactor in inflation and rate hikes, long-term rates in Japan are being
held to 0.25% through the BOJ’s rigid YCC, causing a rapid wideningof the spread between US and Japanese rates. This encourages thebuying of dollars for yen, and the dollar-yen market, which had beenstable at the ¥110 level until February 2022, saw the yen weaken by
40% from March to August (Chart 4). The Ministry of Finance, which
has jurisdiction over currency policy, began intervening by buying
yen and selling dollars when the yen fell to ¥145.90/$ on Sept. 22, its
weakest level since August 1998. This did not halt the yen’s slide,however, and the BOJ intervened for a second time on Oct. 21,
immediately after the yen fell below thepsychological benchmark of ¥150/$.
CHART 3
With these recent exchange rate movements,
Japan’s yield curveand amid the jostling among countries to(%)
prevent their currencies from weakening and
2.0
thereby feeding inflation, Kuroda’s repeated① October 2021 MPM
comments tolerating the yen’s weakness appear⑤② March 2022 MPM
to have held back the Japanese government. As
1.5③ April 2022 MPM
with other central banks, however, the BOJ does④
④ June 2022 MPM
not make policy adjustments to account for③
1.0②
exchange rates, and it should not. If exchange⑤ End-October (as of writing of this article)
rates do affect monetary policy management, it①
would be in cases, for example, where they are
0.5
combined with a spike in resource prices andhaving an adverse effect on the Japanese
0.0
economy. Accordingly, the important thing toconsider when considering the direction ofmonetary policy is not to look for the future-0.5
direction of exchange rates, but rather to analyze
1
2
3
4
5
6
7
8
9
10
15
20
30
40
(Maturity in years)
the effect of current exchange rate movementson the economy and prices.
Note: MPM = The BOJ’s Monetary Policy Meeting. Lines 1-4 show the yield curve during the two days of each MPM.
Source: Bloomberg

44 Japan SPOTLIGHT • January / February 2023

Deflationary Pressure from
Deteriorating Termsof Trade

CHART 4

Dollar-yen exchange rate & Japanese interest
rates(Dollar/Yen)(%)

Drastic yen depreciation like we are seeing
155
4.2
Oct. 20
today significantly raises import prices in yen
Dollar-yen exchange rate
150
¥150.15
terms, and higher costs for imports puts upward
3.8
US-Japan interest rate spread (10-year; right-hand scale)145
pressure on domestic prices. Import prices
3.4
compiled by the BOJ are on a contract currency
140
basis and a yen basis. The contract currency
3.0
135
basis indexes import prices in the currency in
130
2.6
which the importer actually concluded the125
import contract, and the yen basis indexes
2.2
contract prices in yen terms. We are now
120
1.8
beginning to see a drop in resource prices that115
had risen sharply as a result of developments
1.4
110including Russia’s invasion of Ukraine, and the
1.0
year-on-year increase in import prices on a
105
21/6
21/8
21/10
21/12
22/2
22/4
22/6
22/8
22/10
contract currency basis is narrowing. With the(Year/Month)yen’s drastic depreciation, however, the year-onyear increase in import prices on a yen basis
Note: US-Japan interest rate spread is the US Treasury 10-year yield minus the JGB 10-year yield.
Source: Bloomberg
continues to grow (Chart 5).
The rise in import prices (yen basis) not only
CHART 5causes inflation by pushing up domestic prices,
Import prices
it also puts deflationary pressure on theeconomy by curtailing corporate earnings and(Year on year; %)60
retail consumption. This rise in import prices,
Import prices (yen basis)
September
50
which has both inflationary and deflationary
2022
July 2008
Import prices (contract currency basis)
aspects, creates a peculiar phenomenon in
48.0%
40
34.7%
which the GDP deflator falls even though
July 200830
21.8%
Septemberconsumer prices and the domestic demand2022
20
deflator are rising. For the April-June 2022
21.0%
quarter, consumer prices (all items) rose 2.4%
10
and the domestic demand deflator was 2.6%,
0
but the GDP deflator was a negative 0.3%. These-10
twists and turns are created by terms of trade.
-20
Real GDP is a country’s nominal GDP – thetotal of the country’s added value – excluding-30
the effect of price fluctuations, and the GDP-40
deflator shows those price fluctuations. Broadly
06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22
speaking, because GDP is made up of both(Year)
domestic demand and external demand (exports
Source: BOJ
minus imports), the GDP deflator can be
expressed as three variables: the domestic
demand deflator; the external demand-related deflator, in otherdomestic demand deflator and terms of trade. This calculation iswords the export deflator; and the import deflator. The import andshown in Chart 6.
export deflators are used to compile import and export prices. If we
Looking at this chart, the effect from the domestic demand
understand the difference between the export deflator and the importdeflator has recently been rising significantly, while at the same time
deflator to be the change in terms of trade, it becomes possible toterms of trade have deteriorated by an even wider margin, for an
break down the degree to which the GDP deflator is affected by theoverall negative effect, and this can be confirmed by the fact that theJapan SPOTLIGHT • January / February 2023

45

passed by the cabinet on Oct. 28 as part of thecomprehensive economic measures toovercome high prices and achieve economic
revitalization, started at roughly ¥20.0 trillion to(Year on year; %)cover the GDP gap, but grew on requests by
5
Rise in domestic demand deflator
ruling party lawmakers who were concerned
4about the government’s declining approval3
rating, and ended up at ¥29.1 trillion. Despite2
this uncontrolled fiscal expansionism, the factthat long-term interest rates did not react like1
they did in the United Kingdom is because the0
BOJ’s YCC prevented that from happening. No-1matter how much the BOJ itself denies this, themarket sees through YCC as blatant fiscal-2
Terms of tradefinancing. Japan’s fiscal situation is much more
-3
Degree of impact from domestic demand
severe than the UK’s.
-4
GDP deflator
The BOJ governor will be replaced this spring.
Deterioration in terms of trade-5
This change can be seen as a critical moment└11 └12 └13 └14 └15 └16 └17 └18 └19 └20 └21 └22
for the bank’s monetary policy. Markets are(Year)
looking with anticipation toward monetary policy
management after the retirement of Kuroda, who
Source: Cabinet Officestubbornly refused to move towardnormalization. This is true at least for JGB
GDP deflator is negative year on year. It is the deterioration in terms
market participants and financial institutions. If the market becomesof trade that creates deflationary pressure when the import deflator
the price-making mechanism for 10-year yields, it will become clear
rises sharply, and this is the reason Japan’s GDP deflator is notthat the restoration of the bond market, with a yield curve thatrising. This will come as a shock to adherents of the quantitative
conforms to fundamentals and the underlying assumption oftheory of money. From the January-March 2020 quarter to the Aprilarbitrage trading being carried out freely, is desirable.
June 2022 quarter, prior to the spread of the coronavirus pandemic,
The BOJ has two options. One is to continue with unprecedented
money stock (M2), formerly called the money supply, was growing
easing while putting forth policies needed to address its side-effects.
significantly – by 35.1% in the US, by 17.9% in the euro zone, andThe other is to examine its policy, including a review of the positionby 14.3% in Japan – but on the other hand, while the GDP deflatorof its “price stability target” of a 2% rise in consumer prices, and torose to 11.9% in the US and 6.3% in the euro zone, it fell to a
begin normalization. I see the most likely scenario being one in
negative 1.0% for Japan.
which unprecedented easing continues while addressing the sideeffects as long as there is a high risk of a recession in the US and
Outlook for Monetary Policy
Europe, and after that recession ends and an upturn in the economic
environment is confirmed, to embark on a policy review. The
From this, we can say that in Japan we should not look at the GDP
outcomes of the US and European economies and their monetarydeflator for domestic inflationary pressure. The CPI is higher year on
policy management will have a major effect on the BOJ’s actions
year at the 3% level, and the consumption deflator is also above 2%.
during 2023.
In Japan as well – putting aside whether or not it is a temporary
phenomenon – the unbearable inflation that people are facing is a
Note: This article was completed on Nov. 7, 2022.
fact, and this is why the BOJ is coming under increasing criticism forstrictly sticking to the “price stability target” of continuously
achieving a 2% rise in consumer prices and stubbornly continuing
its unprecedented easing.
Maintaining low interest rates is the government’s endorsement ofNobuyasu Atago is senior operating officer and chief economist at Ichiyoshi
populism, but we must not forget the major side-effect ofSecurities Co., Ltd. He worked at the Bank of Japan until 2015. He was also a
chief forecaster at the Japan Center for Economic Research and a chief economist
complacency about the dangers of budget deficits. Discussions
at Okasan Securities. He holds a Master's degree from Kobe University.
about the size of the second supplementary budget (general budget),
CHART 6

Breakdown of degree of year-on-year impact on
GDP deflator

46 Japan SPOTLIGHT • January / February 2023