In terms of monetary policy influencing global liquidity flows, it has clearly been a tale of two central banks. On one side of the pacific, the US Federal Reserve is winding up its unprecedented bond buying program. On the other side, the Bank of Japan has undertaken the largest bond buying program (as a percentage of its monetary base) in financial history.
The Japanese move has counterbalanced the ejection of liquidity in the system. The Bank of Japan (BOJ) has done so for primarily three reasons. One, fight deflationary pressures which have haunted to economy for much of the last 20 years. Two, weaken the Yen to boost exports and also import inflation via higher energy bills. Three, boost general asset prices to create a real wealth effect that would lead to a boost in domestic spending.
To this point, the efforts of the BOJ must be classified as successful till date. The Nikkei 225 has rallied from sub-10,000 levels to 15,000 in just over one-and-a-half years. The yen, too, has depreciated from 80 to 103 against the US dollar, while inflation expectations have shown a consistent uptick.
The consumer price index rose 1.3 percent in February for a third straight month. The unemployment rate is currently 3.6 percent, the lowest since 1998. This has raised hopes of wage increases that would further put an upward pressure on prices. The BOJ has set an inflation target of 2 percent which seems within the realms of possibility if recent data is anything to go by.
But Japan’s economy still faces its biggest challenge after Prime Minister Shinzo Abe’s government hiked sales tax effective Tuesday. The sales tax has been increased, from 5 percent to 8 percent, for the first time in 17 years. This increase is intended to fund Japan’s increasing social welfare costs and its ballooning public debt, which is twice the size of the economy, making it the largest among the developed nations.
It is feared the Japanese consumer would cut back on expenditure post this sales tax hike. Till now, consumer spending has been at the forefront of the improvement in GDP growth. As mentioned in previous report, the yen will move in response to the yield spreads of short-term and long-term US bonds.
However, history can also be used as a guide to help in predicting the movements in equities and the yen in the coming months. According to Kathy Lien, a currency strategist, in the months leading up to the tax increase in 1997, the economy grew rapidly with the fourth quarter (Q4) GDP growth in 1996 hitting a high of 6.1 percent.
Growth remained strong in Q1 of 1997, with GDP rising 3 percent. In the quarter of the increase, the economy contracted by 3.8 percent. Over the next month following the tax hike, the USD/JPY declined 13 percent and the Nikkei fell 28 percent over the next six months. Officials in Tokyo would have this price action at the back of their minds. Thus, they would be ready to get into stimulus mode if weak data persists, post the hike.
For now, bulls on the Nikkei and the USD/JPY exchange rate would be banking on additional stimulus by the BOJ. A slowdown in coming weeks due to the sales tax hike would be treated as a bullish indicator. The Nikkei can see levels of 17,000-18,000 and the Yen can depreciate to levels around 110 to the US dollar in the quarters following Abenomics Version 2.
(Vatsal Srivastava is consulting editor for currencies and commodities with IANS. The views expressed are personal. He can be reached at vatsal.sriv@gmail.com)