Uncertainty Around Japan Inflation Underscores Need for Nimble Monetary Policy

IMF News, May 25, 2023

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Japan’s headline inflation reached a four-decade high in February as the economic recovery continued amid supportive monetary and fiscal policies and a surge in tourism.
Underlying momentum in core prices (excluding fresh food and energy) strengthened further, reaching a four-decade high of 4.1 percent in April.
While lower energy prices reduced inflation in recent months, core inflation and other indicators suggest broader and more durable price pressures.

Inflation initially triggered by the global energy and supply-chain crisis is showing signs of becoming broader and more durable.
The annual ‘shunto’ negotiations signal agreement on larger-than-expected wage gains that better keep up with rising prices.
Business surveys show a sustained increase in inflation expectations, likely to influence corporate price-setting.
IMF staff project inflation to remain above the 2 percent target until the end of next year, driven by the continued surge in tourism and delayed effects of yen depreciation.

Small and medium-sized enterprises that employ more than 70 percent of workers are less profitable and may not be able to afford sufficiently large pay increases, so the expected wage boost may not be enough.
A weakening of the global economy could strengthen the yen, making exports less competitive and potentially returning Japan to low inflation or deflation.
Household surveys indicate inflation expectations remain well below 2 percent.

The BOJ faces the challenge of durably achieving its 2 percent inflation target without significantly overshooting while safeguarding financial stability.
The short-term policy rate remains at minus 0.1 percent, leaving monetary policy ultra-accommodative even as inflation rises.
Under yield curve control, the BOJ pledged to buy as many Japanese government bonds as needed to keep 10-year yields within its target range; this was sustainable until global rate rises created a yield gap and heavy downward pressure on the yen.
Investor speculation that Japan’s easing cycle would end forced the central bank to buy trillions of yen in bonds to defend the ceiling on yields, destabilizing the market.
The BOJ now owns more than 80 percent of outstanding 10-year government bonds, creating rising costs associated with capping long-term rates.

Allow greater flexibility in longer-term yields to let market forces play more of a role and reduce the BOJ’s intervention needs.
Maintain the accommodative stance by keeping the short-term policy rate unchanged until there is more evidence of a durable 2 percent inflation achievement.
Specific options for added flexibility noted in the staff report:
- Widen the target band around the 10-year rate enough for market forces to play a leading role, minimizing continued intervention in the bond market.
- Keep short-term yields low by capping a shorter-term rate instead (for example, the 5-year rate), since short-term yields matter more for real economic activity.
- Shift from a yield target to a quantity-based purchasing objective to avoid the cost of defending a particular yield level.
Policymakers must assess advantages and disadvantages of each approach and potential domestic financial stability implications.

Japan has been the world’s largest net creditor for more than three decades, with external assets of $3.2 trillion.
Rising Japanese government bond yields could lure investors back to domestic assets and attract more foreign investment, potentially hurting the valuation of overseas assets and putting upward pressure on global yields.
Spillover effects could be larger in countries where Japanese investors own a large share of local debt, including several euro area countries, Australia, and the United States.
Clear communication of any changes to Japan’s monetary policy stance will be critical to mitigate unintended consequences and heightened market volatility.

Monetary easing should be supported by other policies, including withdrawal of pandemic-related fiscal support, with any new measures limited and targeted to vulnerable households only to avoid overheating the economy.
Boosting personal income and purchasing power—such as by making it easier for workers to switch jobs and for women and seniors to join the workforce—would help sustain a virtuous cycle of income and growth.
Overcoming structural barriers to wage growth is necessary for durable achievement of the 2 percent inflation target.

Purva Khera and Salih Fendoglu, May 24, 2023, International Monetary Fund