The Ill-Fated Term Awaiting the Next BOJ GovernorEconomy
A Promise Not Kept
Bank of Japan Governor Kuroda Haruhiko will complete his second five-year term on April 8. Prime Minister Kishida Fumio is expected to submit a proposal to the Diet on Kuroda’s successor in February. Whether the new governor decides to maintain the monetary policy “of a different dimension,” the term given to the massive quantitative and qualitative easing measures maintained for many years now, or will seek to revise the policy will greatly impact domestic and foreign financial markets. Who the next BOJ governor will be is a matter of utmost interest for the world of global finance in 2023. For a prime minister whose popularity is declining, the appointment of a person who will become the next pillar of macroeconomic management is not one that can be allowed to go wrong.
When Kuroda became the BOJ governor in the spring of 2013, he declared that he would double the monetary base in two years’ time and would achieve a growth rate of 2% for the consumer price index. Toward this end, he began massive monetary easing that he labeled easing of a different dimension. His strategy was meant to foster inflationary expectations and to bring deflation to an end.
As a result, the current account deposits of private financial institutions at the BOJ, which totaled ¥5 trillion in 2001 when quantitative easing began, grew almost 100 times, to nearly ¥500 trillion (currently about ¥480 trillion). The monetary base, the combination of cash and these current account deposits, has surpassed ¥600 trillion, which is far greater than the size of Japan’s gross domestic product. The Bank of Japan is a clear outlier compared to the central banks of the United States and Europe.
As collateral for this huge supply of liquidity, the BOJ has bought massive quantities of Japanese government bonds through the market, and the share of issued and outstanding JGBs held by the BOJ has surpassed 50%. In addition, the unprecedented purchase of stocks (exchange-traded funds) has reached ¥36 trillion on a book-value basis.
Despite this bold economic experiment, the rate of inflation has never exceeded 2% in the nine years since Kuroda’s appointment. Prices did finally surge in the final, tenth year of Kuroda’s term, but that was not an effect of monetary easing of a different dimension. It resulted from the increase of crude oil prices accompanying Russia’s invasion of Ukraine and from the yen weakening against the dollar due to the aggressive monetary tightening of the Federal Reserve Board in the United States.
The New Governor Will Shoulder an Adverse Legacy
A rate of inflation exceeding 3% is a source of much dissatisfaction among the general public. Governor Kuroda, however, insists that inflation will eventually slow and that he will continue to ease until the stable increase of prices is accompanied by rising wages. Although the trading range of the long-term interest rate was widened in late 2022, Kuroda likely intends to pass on the framework of monetary policy to the next governor in its current form.
In their unwavering self-assessment, Kuroda’s executive officers believe that monetary easing of a different dimension has eliminated deflation, has stimulated the economy, and has increased employment.
However, a completely different landscape is seen from the perspective of the next governor, a vision of an adverse legacy beyond imagination. During the next five years the new governor must shoulder the arduous fate of untangling bloated and complex policies and of normalizing the monetary policies of the BOJ.
While Prime Minister Kishida basically supports a policy of monetary easing, he will want to place some distance between his administration and the reflationary policies promoted by former Prime Minister Abe Shinzō. Hence, he is unlikely to nominate reflation adherents for the posts of governor, deputy governors, and members of the bank’s Policy Board.
Therefore, the newly appointed executive officers of the BOJ, charged with transitioning away from Abenomics, are expected to maintain an accommodative stance for a while in parallel with a thorough examination of monetary easing of a different dimension. They will identify the efficacy and costs of the BOJ’s easing during the last 10 years and, based on their conclusions, decide what should remain and what should be revised.
The Immense Challenge of an Exit Strategy
Governor Kuroda has insisted it is too early to plot a strategy for exiting his different-dimension monetary easing. But the likelihood is high that a technical examination will be made of just this prospect in light of the current economy and the rate of inflation.
The keys to revising a policy of easing are carrying out a dialog with the market and rebuilding a relationship of trust. Lessons should be learned from the Kuroda stance that forfeited the confidence of the market and the public through the deferral of the 2% inflation target and through repeated surprise strategies. The ability to communicate reliably and skillfully is one attribute demanded of the new governor.
In relation to the exit strategy, even if a virtuous circle between wages and prices is realized, the likelihood is high that the new executive officers will maintain the BOJ’s bloated balance sheet and will seek to suppress upward pressure on prices by raising interest on current account deposits at the BOJ.
Interest began to be paid for current account deposits in 2008, and currently some of these deposits carry negative interest. Should these negative rates be ended, and should the interest level be increased in stages, it will be possible to tighten policy without reducing the balance of current account deposits—as has already been undertaken in the United States.
As for the JGBs held by the BOJ, it is highly likely that the central bank will shrink its balance sheet at an extremely gradual pace by reducing its JGB holdings to the extent possible as they reach maturity. This process will be accompanied by strong pressure to sell JGBs. The BOJ will likely suppress the steep rise of the interest rate through yield-curve control and will then carefully examine the timing for letting go of its measures suppressing the long-term interest rate.
However, given that current account deposits total nearly ¥500 trillion, increasing the interest of these deposits by 1 percentage point would give rise to an interest burden of ¥5 trillion, and doing so by 2 percentage points would create an interest burden of ¥10 trillion. Meanwhile, the sharp decline of JGB yields is resulting in a severe negative spread for the BOJ, which is drawing attention to the possibility that the BOJ’s mounting deficit will exhaust its equity capital and tip the central bank into insolvency. Since the BOJ’s worsening financial position may increase the taxpayer burden through the decrease or reduction of payments to the national treasury, this situation risks becoming a political headache for the new governor.
Unlike JGBs, exchange-traded funds have no maturity, making their normalization even more difficult. A number of ideas have been quietly raised on how to avoid influencing the stock market, such as their sale in total to the government. There is, however, the view within the BOJ that retaining ETF holdings would cause no harm since their substantial dividends are effectively supporting BOJ finances.
A Catastrophe in the Making?
As described above, the path toward normalization is precipitous no matter what route is chosen. Depending on the external environment, even taking the first step toward normalization may become difficult. The factors of greatest concern are the direction of the US economy and the situation for Japan’s public finances.
In its outlook for the global economy, the Organization for Economic Cooperation and Development anticipates that the US economy will slow from a growth rate of 1.8% in 2022 to 0.5% in 2023.
Should the United States reverse its current policy of monetary tightening and reduce interest rates, this can be expected to place upward pressure on the yen. A senior BOJ officer has stated that, depending on the situation, Japan may need to ease its monetary policy further. Should the US economy slow and should the sluggishness of the Chinese economy continue, normalization would become the least of Japan’s concerns.
On the other hand, even if the US economy rebounds ahead of the 2024 presidential election, should confidence waver in the sustainability of Japan’s public finances, that would spell game over for normalization.
Should Japan’s ability to earn weaken from a declining birthrate, an aging population, and a low potential growth rate, and should a current account surplus become difficult to maintain, the ability to control the long-term interest rate would be lost in a flash. In such a scenario, the yen would be sold aggressively as seen in the autumn of 2022, and the BOJ would be at a loss in responding to the immense upward pressure placed on the long-term rate.
To avoid this risk, there is no alternative to structural reforms to raise the potential growth rate of the economy and to painful efforts to restore the health of public finances. As underscored by the year-end turmoil over increasing taxes to fund additional defense spending, politicians focused on the next election appear to lack the necessary resolve.
A remaining hurdle is the joint statement that the BOJ issued with the government a decade ago, in January 2013. Such political statements are intrinsically unnecessary. Should the joint statement be retained, it will be necessary to redefine the 2% inflation target as a medium- to long-term target rather than something to be achieved as soon as possible. Missteps in making this revision would risk political discord. For this reason, prominent former BOJ officials have said that careful efforts will be required and that there is no need to hurry in making this revision.
The normalization of monetary easing of a different dimension can be likened to removing the fuses one by one from the huge number of unexploded bombs buried in the financial system and the economy. Mistakes made in their removal, or in the timing for doing so, could set off a catastrophic explosion.
Given this situation, a senior government official has stated that the next BOJ governor will need to be well versed in the history and framework of monetary policy and be a BOJ alumnus. One former BOJ official predicts an arduous term for the next governor, stating that whoever is appointed, the new governor will face a demanding environment like no other in the 140-year history of Japan’s central bank.
(Originally published in Japanese. Banner photo: Following a meeting with Prime Minister Kishida Fumio, Bank of Japan Governor Kuroda Haruhiko responds to the questions of reporters on November 10, 2022, at the Prime Minister’s Official Residence. © Jiji.)