Weaker yen adding more inflationary pressures while BOJ ignores the dangers

As we noted in our last week’s publication, the Japanese currency was unlikely to retain its brief gains it had registered against other major units since its April lows given BOJ’s highly misaligned monetary policy stance relative to other key central banks. Indeed, it took only a day or two, at the start of last week for concerns about global inflationary pressures to reassert themselves, leading to a significant drop in the value of the yen against the dollar, euro, the Korean won and even against the Chinese yuan.

The BOJ governor, Kuroda-san’s latest explanation to parliamentarians that the bank’s loose monetary policy does not necessarily have any bearing on the direction of the currency is blatantly misleading. Moreover, it underlines the dangers of a significant acceleration of inflation rate in Japan as weaker currency only adds more pressure to rising import costs just as global energy prices are surging. We also think that BOJ’s view that trend for higher prices is only transient, a narrative that other overseas economic policy makers have long abandoned, will also prove incorrect.

Indeed, a recent Japan survey indicated that prices of over 8,300 food and beverage items are set to rise by an average of 12% within a year with 80% of these set for price hikes by summer. Moreover, a recent Tokyo University survey of over 20,000 people in key regions showed that 56% of Japanese would put up with a 10% price increase in a regularly purchased supermarket items, compared with 43% in the previous survey last August. While that is still below 64% level shown for the US, it came above those in the UK and Canada. 

With rising inflationary expectations suggesting that price hikes are becoming increasingly embedded into the economy, we highly suspect that BOJ’s view that Japan’s CPI will hover just above 2% for the foreseeable future could also prove hugely off target and we would not be surprised to see the inflation gauge approaching 5% level in second half of this year. The big problem is that Kuroda’s ten-year reign which comes to an end by next April has cleared the decks of any policy hawks at the bank’s board, suggesting that there are little internal pressures for an immediate policy shift, leaving the central bank potentially rudderless in such a high inflation scenario. 

We have already seen industries such as steel manufacturers increasingly question economic policies that have allowed the yen to depreciate, arguing that imported input costs are surging beyond what they could pass on to their key customers such as auto makers. The devalued yen has also created its own vicious feedback loop with Japanese institutional investors such as life insurers having been forced to slash the proportion of the dollar-denominated investments they hedge to the lowest levels in more than a decade as cost of protection has more than doubled due to rising rates in the US. 

Although in the near term, we don’t think that BOJ will make any adjustments to its official discount rate, currently just above zero, we strongly believe that the above scenario will force the bank to stop its interventions in the JGB market which has suppressed the ten-year yield below 0.25%. Another possibility is for the bank to raise its tolerated ceiling to somewhere close to 1%. Either way, we think the yield curve in Japan is poised for a significant steepening sometime this year which should lead to a dramatic outperformance of Japan’s financial sector which has long suffered from BOJ’s ultra-loose policy stance.