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The Bank of Japan’s Moment of Truth

Summary:
After years of deflation, Japan's labor market is the tightest it has been in decades, and the Bank of Japan is still providing significant stimulus to the economy. But with inflation still well below target, central bankers are finding themselves between a rock and a hard place. TOKYO – The Japanese economy has enjoyed seven consecutive quarters of positive growth, with the average annual rate reaching 1.9%. With aggregate demand exceeding potential output by 1%, the country’s “GDP gap” is now positive. Unemployment is down to 2.7%, the lowest level since 1993, and the job-opening-to-application ratio is 1.56, its highest level since 1974, resulting in acute labor shortages in several sectors, including construction, retail, and package delivery. And in January this year,

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After years of deflation, Japan's labor market is the tightest it has been in decades, and the Bank of Japan is still providing significant stimulus to the economy. But with inflation still well below target, central bankers are finding themselves between a rock and a hard place.

TOKYO – The Japanese economy has enjoyed seven consecutive quarters of positive growth, with the average annual rate reaching 1.9%. With aggregate demand exceeding potential output by 1%, the country’s “GDP gap” is now positive. Unemployment is down to 2.7%, the lowest level since 1993, and the job-opening-to-application ratio is 1.56, its highest level since 1974, resulting in acute labor shortages in several sectors, including construction, retail, and package delivery. And in January this year, the Nikkei Stock Average rose above ¥24,000 ($216), its highest level since 1991.

But, while these indicators suggest that Japan is finally out of the woods of more than two decades of stagnation, deflation, and economic insecurity, the headline inflation rate, at just 0.6%, remains far below the Bank of Japan’s 2% target. And, notably, while the BOJ had been attributing low inflation to falling energy prices, energy is now contributing positively to inflation. When fresh food is excluded from the price index, the rate rises to 0.9%, but falls to 0.3% when also excluding energy.

Considering the current labor shortages, why Japan has not experienced a healthy wage-inflation spiral remains a mystery. To be sure, inflation is also missing in the United States and Europe. But the Japanese case is particularly striking. Japan’s real economy has been supported for years by fiscal deficits as high as 6% of GDP, and by extraordinary quantitative easing (QE), which BOJ Governor Haruhiko Kuroda introduced in April 2013. The debt-to-GDP ratio has since risen to 230%, and the BOJ has assumed ownership of more than 40% of outstanding government bonds (JGBs).

The BOJ has maintained its negative policy rate and 0% ten-year-bond rate by purchasing annually ¥80 trillion in JGBs and ¥6 trillion in equities. But, more recently, it has kept the ten-year-bond rate at 0.0-0.1%, while reducing the pace of new purchases of JGBs to around ¥50 trillion, in what some regard as a stealth tapering.

With Kuroda’s term ending in early April, two camps of critics have become increasingly vocal. The first camp, arguing that the real economy is what matters, wants the BOJ to stop providing stimulus and start worrying about its bloated balance sheet.

When the inflation rate moves closer to the target, the BOJ will have to start raising its policy and long-term rates without adjusting the size of its balance sheet – which is exactly what the US Federal Reserve is already doing. Given the low average coupon rate of asset-side long-term bonds, the upward shift of the yield curve will result in a loss for the BOJ (“negative seigniorage”), at least temporarily. In the worst-case scenario, the BOJ could exhaust its capital and require a fiscal injection, which could jeopardize its independence.

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