Japan changed its monetary policy framework, aiming for a zero 10-year government bond yield and a negative short rate to get a positive-sloping yield curve, which will help big banks... It also "promises" to hit the 2% inflation target via massive purchases of stock via ETFs. What can we think of all this?
Japan has these problems:
Japan does NOT have these problems:
Now the "setup" is actually not that complicated: they can't get much growth from a shrinking labor force and they can't fix the government debt problem because low growth and low inflation translate to low government tax income.
They can't increase taxes or cut government spending to fix the debt problem because it might worsen the sluggish growth issue. But they can't increase government spending (and debt) to "boost" growth either, because the debt load is quite high and increasing it significantly may eventually cause serious problems.
To at least help, the BOJ (Bank of Japan) has tried to inflate prices by printing money and using the printed money to buy government bonds... but it ran out of bonds to buy and it wants to stop bond prices from going higher, because it wants the 10 year bond yield to stay at zero, which means prices of bonds can't rise too much (prices and yields go in opposite direction).
Why do they want to inflate the economy? This would be a long explanation about debt-deflation, but I will cut short and oversimplify: because if prices increase faster, so do tax receipts for the government! Plus if people expect prices to rise, they buy more now (because it will be costlier later), and that boosts demand, production, and growth in the short run.
Since they 1) can't get extra tax income by increasing taxes (it would slow growth even more) and 2) they can't cut government spending (it would cause sluggish growth to worsen), then the only "outlet" is inflation: print money to inflate prices and boost growth and fiscal income.
How does a central bank inflate prices? It prints money by literally adding to its money in its "bank account" by punching in "plus 1000 billion" (or whatever amount) and using the proceeds to buy assets such as bonds, stocks, other currencies such as USD, land, and whatever else. This extra cash then boosts asset prices and increases the availability of loanable funds, which makes us all richer (asset prices) and more in debt due to the credit expansion, which itself it supported by the rising value of the collateral - the inflated assets! Get it?
If you are thinking that this is crazy, well, you are kind of right. This is an oversimplified version of what we are all doing right now: USA, Japan, Eurozone, UK, etc. But I digress... Back to Japan...
So lets back up and clarify this:
We all know that GDP is income that comes from production activity, and all this generates expenditures in the form of household consumption (C), private sector investment in housing, machines and material, etc (I), government expenditures (G), and net exports (NX = exports minus imports)... So, GDP = C+I+G+NX.
To get extra net exports in the SHORT run, you can print lots of JPY and buy USD in forex (equivalent of "buying" the USD/JPY pair for you forex traders out there), which makes Japanese goods cheaper and helps the big exporters, which boosts growth.
That is what the BOJ is talking about. But what makes the goods of Japan competitive in global markets is the actual price the exporters charge combined with the exchange rate effect. So if JPY appreciates 10% but exporters cut prices by 10% (deflation), the price for the US buyers remains the same... and that, my friends, is what has been happening. Below is the REAL effective exchange rate for Japan. A drop means that Japanese goods are less expensive in global markets (more competitive).
As you can see, there is a long run downtrend: prices of Japanese goods are falling relative to the rest of the world, which means Japanese exports are more and more competitive. Deflation that hurts government tax receipts actually helps exports. Deflation means they are more and more competitive because their prices are falling while the prices of others are rising... BUT... the recent rise of the real exchange rate since early 2016 (caused by JPY appreciation) is adding deflationary forces and causing problems to the big Japanese exporters, and it is obviously starting to put pressure on the BOJ to do "something" to avoid the appreciation.
Between a rock and a hard place
So why won't the BOJ print extra money and simply let JPY depreciate massively to boost exports, as it did back in 2012, 2013, and 2014? Well, this may actually be coming, as it seems it is the last card in their hands. But perhaps they are also pondering the longer term impact of a rise of inflation to 2%: prices would rise at the same pace as elsewhere, and that higher inflation would kill their competitive edge induced by deflation via the real effective exchange rate.
The other issue is that in the long run, rising inflation would boost long term interest rates. Now imagine the interest rate payments to be done on a 230% debt-to-GDP government debt if rates rose only from 0% (no interest payments) to 1%: 1% of 230% of GDP = 2.3% of GDP in interest payments alone, and that means the interest payments to be made would likely rise above annual GDP growth... An impossible setup that could end with a bond market crash.
Of course, the government debt could all be rolled over 100% to the 0-1 year segment, which the BOJ can keep at 0% or negative, but that would mean a huge scarcity of 10-year bonds, a jump in prices, and a fall in 10-year yields from zero to negative again (which they said they don't want), making the yield curve turn negative again, and causing problems to banks. A negative yield curve means that long term rates are lower than short term rates. Since banks borrow short term to lend out longer term at higher interest rates, a flat or negative yield curve causes big problems for banks. This is why the BOJ wants long term rates to be zero and short term rates to be negative: to help banks with a slightly positive yield curve.
One last issue is capital flows: if the BOJ was to convincingly depreciate JPY by printing money, currency risk would rise on JPY, causing capital to leave the country. Now it is not that bad for Japan, because Japan is a net SUPPLIER of global capital. But still, the capital outflow would be disruptive to financial markets and banks, which would then have to be supported by the BOJ.
Japan can't increase taxes or cut government spending to fix the debt. Japan can't boost growth with massive tax cuts of government expenditures due to the already-high debt, and can't count on household consumption or private investments. Japan can't hope for a rapid shift in average growth due to demographics.
The last card is exports. Inflating and causing a nominal depreciation might help in the short run, but could boost interest rates and the debt service later OR cause a problem for banks that would face a negative-sloping yield curve.
In the end, unsustainable debt loads ALWAYS end up in one of 3 ways:
What to make of all this? In short, they are stuck. Expect back-and-forth, incoherent policies to inflate and depreciate, then backing off and having trouble with their yield curve management framework. Traders can make a fortune by being long and short JPY during these policy shifts.
If (a big "if" by the way - believe when you see it!) they truly decide to "print and inflate", that printed money will HAVE to "land" SOMEWHERE... and that somewhere will have rising prices during the phase of monetary expansion:
These are the four "outlets" that will absorb the BOJ printed money if it ever comes. Keep it it mind - it may come in handy! Cheers!