Two years after Haruhiko Kuroda, governor of the Bank of Japan, declared his team will "do whatever it can" to end deflation, it's painfully clear their efforts aren't working.
Stocks are up, bond yields are down and people are buzzing about Japan for the first time in years. What's still missing, though, is any hint of the self-sustaining recovery Kuroda hoped to be touting by now. With annualized growth of 1.5 percent between October and December after two straight quarters of contraction, Japan is hobbling out of recession far more slowly than hoped. A third dose of quantitative easing is almost certain. Here are three reasons why.
First, the initial rounds of QE weren't potent enough. "In order to escape from deflationary equilibrium, tremendous velocity is needed, just like when a spacecraft moves away from Earth’s strong gravitation,” Kuroda recently explained. “It requires greater power than that of a satellite that moves in a stable orbit.” Although the Bank of Japan managed to lower the value of the yen by more than 20 percent beginning in April 2013, that clearly hasn't provided enough of a boost to the economy. (Net exports, for example, added just 0.2 percent to fourth quarter GDP.) Meanwhile, the bank's 2 percent inflation target looks more and more distant. The BOJ’s main inflation gauge slowed to just 0.2 percent in January, down from 1.5 percent in April last year.
The trouble with the first two rounds of QE was both the size and the strategy. While undoubtedly huge, neither injection was aggressive enough to, at Kuroda puts it, "drastically convert the deflationary mindset." Also, the BOJ must get more creative than just hoarding government debt. This time, the BOJ should pledge bond purchases of closer to $1 trillion a year and buy bigger blocks of asset-backed, mortgage-backed and corporate securities; load up on distressed assets, including property in rural areas; and prod the government to tax excessive bond holdings by banks and households.
Second, the Federal Reserve is complicating Kuroda's job. With U.S. unemployment falling to 5.5 percent in February, the lowest level in almost seven years, U.S. interest rates will soon be heading higher. On Friday, Fed Bank of Richmond President Jeffrey Lacker employed his own cosmic imagery when he declared: "June would strike me as the leading candidate for liftoff." Monetary largess isn't exactly a zero-sum game, but the Fed's QE experiment supported asset markets from London to Tokyo as much as it's enlivened U.S. demand. As the Fed withdraws, Kuroda will face pressure to make up the difference.
There's an argument to be made that as the Fed tightens, the dollar will rise versus the yen, providing its own measure of stimulus to Japan. "They don't care about global liquidity," says economist Richard Jerram of Bank of Singapore about Japan. "They care about the exchange rate." But improved exchange rates may not cut it for Japan; the weak yen hasn't been fattening Japanese paychecks as BOJ once hoped. Take Toyota, which is arguably benefiting most from the BOJ's policies. Last month, its workers asked for a piddling $50 monthly wage hike from a corporate giant projecting a record $18 billion profit for the year. Toyota is balking at sharing just four days of profits with the salarymen and women whose sweat helps fill its showrooms and coffers. More QE, structured wisely, might both increase demand for credit and give corporate chieftains greater confidence in Tokyo's determination to end the country's two-decade-long funk.
The third reason to expect another round of QE from Japan is that monetary policy is the only active game in Tokyo. Prime Minister Shinzo Abe's revival program was supposed to include three elements: monetary stimulus, fiscal expansion and deregulation. But the third stage -- including pro-growth steps like lowering trade barriers, loosening labor markets and encouraging entrepreneurship -- never materialized.
And in the year ahead, Abe's focus will almost certainly be on geopolitical concerns, not retooling the economy. Despite winning a fresh electoral mandate in December to implement phase three of his economic plan, he has devoted most of his efforts since then to security policy -- specifically, to reinterpreting the postwar pacifist constitution to allow Japan to defend itself and allies abroad. This push gained renewed urgency after the beheadings of two Japanese in Syria in January. The trouble is, all of the structural economic reforms Abe has promised would boost wages, encourage a start-up boom and raise competitiveness have been put on the back burner.
As long as Abe is distracted, Kuroda and his BOJ staff are the only ones who can do what's necessary to convince markets that Japan is still intent on making a comeback. That's why all signs point to QE3 in the weeks or months ahead.
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