Japan: Inflation needs to pick up - Nomura

If inflation surprises positively in 2018, real yields in Japan will be even lower and there would be room for the BOJ to consider gradually adjusting its 10yr yield target, suggests the research team at Nomura.

Key Quotes

“On 13 November, Governor Kuroda praised the positive impact of QQE, stating that “through a rise in inflation expectations and a substantial decline in longer-term interest rates, the Bank has succeeded in reducing real interest rates to levels well below the natural rate of interest for the first time in its two-decade-long battle with the zero lower bound on the short-term policy interest rate.” While the BOJ’s policy framework has changed from QQE to YCC, the BOJ continues to stress the importance to lower real interest rates.”

“In the latest summary of opinions at the MPM, one member noted that “the framework of yield curve control incorporates a mechanism in which a rise in inflation expectations leads to a decline in real interest rates, thereby enhancing monetary easing effects,” and that “it is therefore possible to enhance momentum toward achieving 2 percent by maintaining the guideline for market operations.” These suggest the BOJ will allow inflation to rise without hiking rates for the time being, to lower real interest rates.” 

“When the BOJ added stimulus in October 2014 (QQE 2), core CPI inflation (excl. fresh foods) remained around 1.0%, while BOJ core CPI inflation (excl. fresh foods and energy) was around 0.7%. In January 2016 when the Bank introduced the negative rate, BOJ core inflation was around 1.3%. To embark on the exit policy, inflation likely needs to accelerate to at least around 1.0%, but BOJ core CPI inflation is still just at 0.2%.” 

“If inflation accelerates, the Bank will likely allow 10yr yields to fluctuate in a wider range around 0%. Our economists examined five risk scenarios in which the BOJ amends its current policy framework. The most likely risk scenario to us is that the BOJ amends its longterm interest rate target in response to an unexpected rise in inflation; other risk scenarios look very unlikely to us. Before such a risk scenario materialises though, there would need to be more external tailwinds to raise inflation and inflation expectations, which would likely lead to JPY weakness.”