CONTRIBUTORS
Kazuto Doi, PhD
Hiroyuki Kimura
The main message the market took from Bank of Japan (BoJ) Deputy Governor Shinichi Uchida’s speech in Nara on February 8, 2024, was that the removal of negative interest rates is almost a done deal and that the BoJ is cautious about raising policy rates even after the removal of negative rates. In other words, the understanding is that the BoJ is more dovish than market expectations. However, the takeaways from Uchida's speech are way beyond mere dovishness; there is much in the content of his speech to consider regarding implications for future market trends.
In particular, the speech section titled ‘‘IV. A Turning Point for Japan's Economy,’’ importantly made the following points: 1) the central issue for the Japanese economy is ‘‘strengthening growth potential,’’ 2) ‘‘ultra-loose monetary policy’’ will create a true ‘‘labor shortage economy’’ where labor cannot be kept on without raising wages, thereby causing ‘‘reform’’ and ‘‘metabolism’’ based on ‘‘workforce perspective,’’ 3) such a move will lead to ‘‘strengthening the growth potential’’ of the Japanese economy, and 4) although such a move will increase the number of bankruptcies of companies that do not meet the needs of workers, the number of unemployed workers is unlikely to increase meaningfully under a ‘‘labor shortage economy,’’ thereby containing the cost of structural reforms.
Furthermore, it has been pointed out that the process from the aforementioned ‘‘labor shortage economy’’ to ‘‘transformation’’ and ‘‘metabolism’’ did not progress for three reasons. First, both potential growth and expected inflation were very low under the stagnant Japanese economy and deflationary environment since 1998. As a result, extreme efforts to overcome the ‘‘zero percent barrier’’ were necessary to achieve the effects of monetary policy easing under the extremely low natural rate of interest. Second, the transition to a ‘‘labor shortage economy’’ took time due to excessive competition, chronic lack of demand, weak labor demand and concerns about employment, as well as the existence of various safety nets. Third and last, there was a deep-seated social practice (and norm) that wages and prices would not rise.
Considering that structural issues such as ‘‘strengthening growth potential’’ are outside the scope of monetary policy and should be addressed as economic policy, we see a painful overlap between Uchida’s logic, which attempts to link monetary policy and ‘‘strengthening growth potential’’ and the BoJ’s approach, which has been struggling alone for decades alongside the government's inaction.
According to Uchida's logic, continuing monetary easing (i.e., keeping interest rates below the natural rate of interest) even after lifting the negative interest rate policy would promote the process of a labor shortage economy, promoting structural reform, which in turn would result in enhanced growth potential and establish a virtuous cycle process between prices and wages. By such a process, inflation and the economy would both accelerate because the degree of monetary easing increases as the natural rate of interest rises along with the strengthening of growth. Even if short-term interest rates remained low, there would be upward pressure on long-term and very long-term interest rates. The yen should also rise. Of course, we do not know how long this process will take, but the direction is upward for both long-term interest rates and the yen. In other words, the continuation of ‘‘zero-interest-rate-like’’ policies after the lifting of negative interest rates as stated in Uchida’s speech does not necessarily hold a dovish implication.
However, there seems to be a disconnect between Uchida’s logic and the current events of two consecutive quarters of negative real gross domestic product (GDP) growth in Japan and the relentless depreciation of the yen. One hypothesis is that the supply capacity of the Japanese economy is weaker than most expected. In this case, the current natural rate of interest could be much lower and the current degree of monetary easing could be very small. For example, if the natural rate of interest is -1% and the expected inflation rate is +1%, the degree of monetary easing after the lifting of negative interest rates would be almost neutral. The -1% natural rate is also within the range of current academic estimates, and the +1% expected inflation rate is consistent with the level of the long-term expected inflation rate priced in the breakeven curve of inflation-linked bonds. In fact, we cannot easily rule out the possibility that this hypothesis is valid. As such, the current level of long-term interest rates and the yen are likely to remain at about the current level, and monetary easing will likely need to be strengthened. If not, we could end up backsliding into a pattern of economic stagnation and deflation after 25 years of solitary struggle. Ultimately, the question is whether the current degree of monetary accommodation is really sufficient.
If this worry is unfounded—that is, if the process follows Uchida’s logic—we can expect long-term interest rates to move toward a level above 1%. As Uchida noted in his speech, interest rates are ultimately determined by macro fundamentals such as the economy and prices, not by BoJ policy.
Nevertheless, the natural rate of interest and the expected inflation rate are all concepts that are difficult to observe. This is precisely why it is important to restore the market function of the yield curve, including maintaining long-term interest rates’ role as the ‘‘canary in the coal mine,’’ in order to accurately estimate the degree of monetary accommodation needed during the current difficult period.
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