Richard Koo is the brilliant Nomura economist who developed the framework of a “balance sheet recession” to characterise periods where private enterprises seek to reduce debt, rendering monetary policy largely useless, and thus requiring aggressive fiscal stimulus.
As such, Koo has not hopped on the Abenomics bandwagon, which places a heavy emphasis on the Bank of Japan engaging in stimulus.
The BOJ’s stimulus has so far caused the stock market to surge, the yen to fall, and even long-term Japanese bond yields have had some big up moves, and this is what concerns Koo.
In his latest note, he warns that the Bank of Japan needs get out in front of inflation worries, and state that although it’s targeting 2% inflation, it won’t tolerate hotter inflation than that.
What can the BOJ do? To begin with, the Bank and the government could make it clear that they are targeting a 2% rate of inflation but at the same time, they will not under any condition tolerate a significant overshooting of that rate.
The Bank of Japan has built up an enviable record as an inflation fighter over the past 30 years and in the process won the public’s trust. Accordingly, I think such a declaration would still carry a lot of weight. By stating that they will not accept an overshooting of the target, the Bank of Japan and the government could reassure the markets that there will be no plunge in the yen and no bouts of uncontrollable inflation.
I think the risk of a sharp rise in long-term rates will also be significantly reduced if the BOJ can successfully communicate these points to the market. The yen’s rapid decline—which contributes directly to inflation—and stocks’ sharp rise in recent months has raised the possibility of such an overshooting. I think it would be appropriate for the BOJ to consider adjusting the pace of easing going forward in response to these unexpectedly quick improvements.
I think it is also important for the Abe administration to dispel the perception that its scenario for economic recovery is heavily dependent on BOJ policy by placing greater emphasis on the second and third components of Abenomics. If the government is seen as relying excessively on monetary policy at a time when everyone recognises that the second and third components are essential for a longer-term recovery, the whole enterprise could be stopped in its tracks once monetary policy is perceived as having run up against the wall because of a rise in long-term rates, etc.
One of the beautiful things about Abenomics is the perception of recklessness. People can’t believe Japan’s chutzpah, as Japan has now essentially committed to being irresponsible, which is very difficult for central banks to do. Coming out now, and promising that inflation would be hard-capped at 2% would reintroduce that perception fo responsibility, and the fears that the old BOJ had come back would materialise.
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