Above-target inflation unlikely to persist beyond one year

Since the BOJ widened its YCC band for the 10y JGB yield on 20 December, markets have been focused even more keenly on incoming CPI data for clues to what the BOJ may do next. The November nationwide core CPI (headline CPI ex fresh food), released on 23 December, was roughly in line with the consensus forecast at +3.7% YoY, a nearly 41-year high, up from +3.6% in October. November was the eighth consecutive month of core-CPI inflation above the BOJ’s 2% inflation target. Nonetheless, November’s core CPI print is unlikely to prompt another BOJ policy adjustment.

Energy continued to boost the YoY core CPI in November. Although gasoline prices were down YoY, much of the rest of the energy sub-basket was priced higher than in the year-earlier month, including electricity, piped-gas and kerosene. Additionally, core (i.e., ex fresh food) food prices jumped 1.1% MoM in November, driven largely by milk, yogurt, cooking oil and bread price increases. Core food contributed +0.2ppt to November’s YoY CPI inflation rate. The December nationwide core CPI is projected to come in at +4.0% YoY.

From January, however, we expect the YoY core CPI to rapidly disinflate, dropping below 2% by July and ending 2023 in the vicinity of 0%. Disinflationary factors set to feed through to the CPI from early 2023 include fiscal policy measures approved last autumn to curb energy inflation, a recent downturn in crude oil prices and retracement of yen depreciation. We are forecasting YoY core-CPI inflation of +3.2% for FY22 and +1.9% for FY23. In FY22, the YoY core CPI has risen above the BOJ’s +2% target as a result of energy and goods inflation compounded by unprecedentedly precipitous yen depreciation. Above-target inflation will likely be confined to FY22, however. We see the FY23 core CPI back below 2%.

YCC adjustment: face-saving deal between Kuroda and BOJ executive staff?

The BOJ’s 20 December YCC adjustment was presumably a response to strong criticism from the government, Corporate Japan and the public, all of which blamed the BOJ’s rigid policy stance for exacerbating yen depreciation. The YCC adjustment was likely an attempt to repair the BOJ’s relationships with these three constituencies. It may have also been intended to facilitate a smoother policy transition for Governor Kuroda’s successor by injecting more flexibility into the BOJ’s policy framework and expediting policy normalization. Kuroda himself, however, was probably not so gung ho about the idea. I surmise he reluctantly agreed to it at the last minute at the urging of the BOJ’s executive staff. In the aim of attaining sustained 2% inflation during his governorship, Kuroda had previously insisted he would never dial down the BOJ’s monetary accommodation one iota. Because the YCC adjustment left the BOJ’s accommodative policies and QQE+NIRP+YCC framework essentially unchanged, Kuroda was able to stick to his narrative to arguably save face.

Meanwhile, the BOJ executive staff are concerned that the environment surrounding BOJ monetary policy has deteriorated. They want to remedy the situation because they will remain involved in conducting monetary policy under Kuroda’s successor. The YCC adjustment gave them more policy flexibility and a better chance to repair the BOJ’s relationships with the government, the corporate sector and the public. In sum, the BOJ executive staff won a substantive policy concession in exchange for allowing Kuroda to keep his narrative in play. Such give and take was probably how December’s YCC adjustment came about.

Financial markets’ perception of YCC adjustment as de facto rate hike is BOJ’s fault

In financial markets, the latest YCC adjustment is widely seen as a de facto rate hike. This perception has spawned deeply rooted speculation that the BOJ will make another policy adjustment relatively soon. With the BOJ’s 10y JGB yield target unchanged at 0%, the YCC adjustment was not officially a rate hike. However, the BOJ had previously said it would not allow the 10y yield to rise by adjusting its YCC band because doing so would be equivalent to a rate hike and negatively affect the economy.

After widening the band, the BOJ now claims the move was not a rate hike and will not have negative economic repercussions contrary to its previous protestations. This about-face is hard to swallow for many people. At any rate, the BOJ’s own words are responsible for financial markets’ perception of the YCC adjustment as a rate hike. Additionally, this perception, coupled with growing speculation about additional policy adjustments, is contributing to financial market volatility, particularly in the 10y JGB yield and USD/JPY rate.

Are increased JGB purchases at odds with YCC adjustment?

After widening its 10y yield band, the BOJ ramped up its JGB purchases to cap the 10y yield. While an increase in the BOJ’s JGB purchases is directionally counter to the YCC adjustment, the BOJ is presumably placing priority on keeping the 10y JGB yield from rising too much following the YCC adjustment. If the BOJ succeeds in doing so, it would likely scale down its JGB purchases to below their pre-20 December run rate in the aim of improving JGB market liquidity and reducing the risk of debt monetization. However, with the 10y JGB yield pinned near 0.5%, the 10y band’s new ceiling, the BOJ may be forced to continue purchasing JGBs in larger quantities than before 20 December. If so, the possibility of the BOJ being forced to take additional action such as widening its 10y yield band again or scrapping the band altogether cannot be ruled out even during the remainder of Kuroda’s tenure.

However, long-term UST yields are expected to drift lower as the US economy progressively slows and Fed rate hikes taper off. Such a scenario would exert downward pressure on long-term JGB yields also. The BOJ is consequently more likely not to be forced to take additional action before Kuroda’s tenure ends.

Two possible paths to policy normalization

Whoever is appointed to succeed to Kuroda, I expect the BOJ’s executive staff take the lead in engineering a policy pivot toward greater flexibility and normalization. Broadly speaking, the BOJ could pull off such a pivot in one of two ways. First, it could do so on the grounds that its 2% inflation target has been largely attained. Second, it could acknowledge that its inflation target has yet to be attained but proceed with policy normalization after indefinitely lengthening the target’s timeline and unlinking the target from conduct of monetary policy. When the BOJ actually embarks on policy normalization, it is much more likely to opt for the second approach than the first.

No virtuous wage-price spiral

Given the upsurge in CPI inflation in 2022, wage increases should be bigger than usual in 2023. Yet the spring 2023 unionized wage negotiations will most likely yield an average base wage increase of at most just over 1%, far short of the 3% base-wage increase that the BOJ deems consistent with attainment of its 2% inflation target. Japanese exporters’ earnings environment could take an abrupt turn for the worse in 2023 in the wake of deterioration in the export environment and yen appreciation. Additionally, with the economy as a whole weakening, Japanese companies will likely turn more cautious on wage hikes as 2023 progresses. If so, the average base-wage increase negotiated in spring 2024 could very well be back below 1%. The pop in CPI inflation in 2022 and prospective pickup in wage growth in 2023 are both unlikely to last longer than one year. We see little if any prospect of a virtuous wage-price spiral leading to stable 2% inflation.

Soft vs. hard policy adjustments

Accordingly, before exiting NIRP and/or otherwise normalizing policy, the post-Kuroda BOJ will have to switch to a more realistic inflation target (e.g., a long-term 2% target) and unlink the target from how it conducts monetary policy. Monetary policy adjustments can be categorized as either “hard” or “soft.” The former are concrete policy changes like exiting from NIRP; the latter, adjustments that lay the groundwork for hard policy adjustments, such as resetting the 2% inflation target’s timeline. The 2% inflation target’s timeline could be reset either by the BOJ acting independently or through a revision of January 2013 Joint Statement of the Government and the Bank of Japan on Overcoming Deflation and Achieving Sustainable Economic Growth. If the reset is done through a revision of the joint statement, it could even happen soon after Kuroda’s successor takes over. That said, the BOJ probably prefers to not revise the joint statement.

While such a soft policy adjustment may occur in 2023 after Kuroda has stepped down, the outlook for the first few months of the year calls for global economic deterioration, sharp disinflation, yen appreciation and mounting expectations of Fed easing. If such an outlook proves accurate, we would expect the BOJ to hold off on policy normalization until mid-2024 at the earliest. Now that YCC has been heavily watered down by December’s major widening of the 10y yield band, we expect YCC to be relegated to a new role of safeguarding against the risk of a large rise in long-term JGB yields when NIRP is abandoned, after which we expect YCC to be discontinued.

• Takahide Kiuchi

  Executive Economist