Abstract

New approach of BoJ towards forex market interventions is described. Unintended consequences of new policy implementation are discussed. Alternative methods of lowering inflation at disposal of BoJ are considered; possible outcomes for different scenarios are outlined and their impact on JPY exchange rate is put forward.



For years now central bankers around the globe are trying to convince public that inflation is indispensable constituent of healthy economic growth and should be greeted with optimism as harbinger of coming prosperity. There is one caveat though they say, it should be rightly dosed at 2% annual rate; any readings below the desired level is deemed as counterproductive.

Considering relatively low levels of inflation in Japan over the last decades, at least according to government statistics, the aim of reaching “the target level” seems to be hard to achieve.
Considering that over the last decade inflation in Japan, at least according to government statistics, stayed at relatively low levels, the aim of reaching “the target value” might seem to be very hard to achieve.


Indeed, it is rather difficultto overcome deflationary forces in highly indebted economy with strong and appreciating national currency, persistent for decades trade surpluses and high level of savings. For monetary authorities of Japan the main “culprit” backstopping economy from running “coveted” levels of inflation was obvious – strong yen.


When highway to prosperity becomes the dead-end street of stagflation

Over the last two decades Bank of Japan has earned itself the reputation of notorious forex market interventionist. During the time span from January of 1991 to March 2011 BoJ intervened in forex market 345 times either by selling yen or buying it (fig. 1); there were only 32 interventions aimed at buying JPY, all of them occurred in 1991-93 and in 1997-98 with overall volume of deals at around 4.88 trln yen. These multiple attempts to weaken national currency against USD had limited effect despite significant size of yen sell-offs – JPY down spikes were short-lived and miniscule in amplitude, while the upward trend was intact.

Data source: St. Lois Fed
Note: data for 2011 includes data from January the 1st to March the 31st
Fig. 1. The annual size of purchases (+) or sales (-) of USD against JPY conducted by BoJ, 100 mln JPY

In 2003 BoJ sold yen against US dollar 82 times (!) in total amount of 20.2 trln yen (fig. 1). Yet, Japanese yen appreciated against US dollar about 7% over this time span. During 2004 Bank of Japan intervened 47 times. Albeit annual aggregated volume of yen sell-offs reached 14.7 trln yen, the desired effect was not achieved – yen strengthened by 6% (fig. 2).

Data source: St. Lois Fed
Fig. 2. Annually averaged daily rates USDJPY at noon EST (bid)

In the aftermath of financial crisis of 2007-09 yen remained strongly bid and went up against USD by about 30% over 4 years. In 2011 when JPY reached its all-time maximum against USD Bank of Japan embarked upon new policy – it began increasing its balance in dollar denominated assets (fig. 3) and yen denominated assets (fig. 4). The entirely new approach began bear its fruits within a few months after commencement. Foreign reserves of BoJ went up by 20% in 2011 (fig. 3) while total assets increased by about 15% (fig. 4) over the same period of time; the upward trend in JPY was stopped and successfully reversed next year.


Data source: St. Lois Fed
Fig. 3. Total foreign reserves excluding gold for Japan, trln USD

What made this approach new is the scope of increase of central bank balance sheet – between the beginning of 2012 and summer of 2014 the total assets went up 100%. Obviously, flooding financial system with free credit created enough liquidity to flow into foreign assets, that lead to sustainable depreciation of national currency.

Data source: St. Lois Fed
Fig. 4. Total Assets of BoJ, 100 mln JPY

The assessment of success of new BoJ policy is up to the judgment of spectator and depends on the point of view. On the one hand – yen has weakened considerably and the “desired” levels of consumer price inflation have been brought about, on the other – the trade surplus became the thing of the past: for the third year now Japanese economy runs increasing trade deficits (fig. 5).

Data source: St. Lois Fed
Fig. 5. Annual net trade: value goods for Japan, bln USD

Considering the unintended consequences of new policy, it should be noted that inflation in consumer prices have not stopped at “coveted” 2% level, but kept on creeping higher – in June 2014 National Consumer Price Index reached 3.6% (YoY). More that that, encumbered by ever growing debt, high inflation and weak national currency Japanese economy contracted – according to recently released preliminary data, GDP went down 6.8% (YoY) in the second quarter of 2014. The best term to describe the current state of economic affairs in Japan would be stagflation.


When a step back is a leap forward

Now, as promised bout of prosperity failed to materialize, economy of Japan faces a formidable challenge of high inflation in consumer prices. The ordinary measure to quench inflation would be to raise interest rate above the level of inflation by 500-700 b. p. and hold it there until inflationary pressure subsides. Indeed, this mode of actions would have devastating effects – the asset prices would collapse, rendering the overly leveraged financial system insolvent. For obvious political reasons the probability of rate hike by BoJ in foreseeable future is negligibly small. Fortunately, there are other means to tame inflationary forces.


Bank of Japan accumulated vast reserves of assets, denominated in US dollars, that can be sold in open market. The proceedings must be converted into JPY, that should be either retired or channeled back into domestic financial markets. Either way, this mode of actions, perpetrated by Bank of Japan, would lead to strengthening of national currency. Strong yen would reduce the price of commodities for industrial producers, and create conducive conditions for running trade surpluses that would buoy national currency. This virtues cycle will not completely wipe the inflation off, but contain it.
Indeed, there is the third option: Bank of Japan might pretend that inflation is non-existent problem and do not change anything in its current policy. In this case yen will keep going down, inflicting more damage to economy and sowing the seeds of much more drastic monetary measures in the future.
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