Japan’s government and central bank have been on high alert for the past year. The Nikkei stock index has had a torrid time of late, with fears of a bank crisis in Japan, the world’s second-largest economy, and the likelihood of a recession in the country, its second largest, having played out in the media.
As a result, the BOJ has deployed all its tools to cool the asset price bubble in Japan and the Yen has been reactivated. This has played out in the markets and the currency has retreated to its earlier levels, with the Yen falling again this morning.
Today’s action highlights the sensitive nature of monetary policy vis-a-vis the risk of asset price bubbles. It is also a reminder that a central bank’s policy response to individual market conditions is not always the most obvious one: Bubbles are always a risk, no matter how much we want to believe otherwise.
The Nikkei’s decline
The Nikkei fell by over 6% on Wednesday January 8, led by a sell-off in stocks on Wall Street. The Nikkei closed down over 6% on the week, the worst performance of any top stock market in history.
Investors worried about the risk of asset price inflation in Japan led to an interest in the Yen. The Yen was up over 3% against the dollar on the day, and has dropped back to around where it was on the day of the Nikkei’s decline.
The government and BOJ policy response
On the same day that the Nikkei’s closed over 6%, Japan’s government responded to the concerns of investors by hiking its own interest rate. The government doubled the Japanese interest rate to a record-high of 0.25%, and increased the mortgage rate as well.
The central bank, the Bank of Japan, has responded to the market’s concerns about asset price inflation with interest rate cuts and a massive monetary stimulus, along with a promise of more to come if necessary.
The Yen reactivation and outlook
The Yerys have been reactivated in part due to a surge in global oil prices, which has led to a sell-off in various commodities and an increase in demand for Yen around the world. Japan accounts for about 20% of that demand, and the yen has fallen against the dollar this week as a result.
The outlook for the Yen is positive, however, due to increasing demand for Japanese commodities and the belief that the central bank will continue to intervene in the financial markets.
In other words, the Yen is likely to remain above $1.30 for the next few months, even as oil prices continue to rise.
What does a Japanese economy slump mean for the Yen?
When a major economy such as Japan suffers a severe economic downturn, central bank policy is often the main trigger. In Japan, the Bank of Japan’s (BOJ) monetary policy has been extremely expansionary for the past few years.
The BOJ has bought over $100 billion worth of mortgage bonds and quasi-equity stakes in banks, as well as advanced-currency exchange bonds. The BOJ has also bought government bonds in various countries, including Japan, in an effort to expand its balance sheet.
Investors who follow the Japanese market closely are aware of the risks of a Japanese bank crisis, but they are also aware that the government and the central bank are prepared for any scenario. In other words, the Japanese financial system is well-oiled, and it would take a catastrophic event – like a major earthquake – to disrupt it.
That said, could a Japanese economy be in a slump? The short answer is yes, but it’s not the one we’re used to seeing in Japan.
The Japanese economy is still very much in the middle of an extensive economic recovery, which is expected to continue for the next several quarters. Tokyo’s economy is expected to grow between 2% and 3% this year, and next year.
At the same time, the Japanese government has dramatically increased its spending in recent years, often in an effort to respond to the country’s notoriously tight labor market. The Japanese government has also been purchasing a large amount of financial assets in an effort to bolster its weakening financial position.
All of this spending by the Japanese government has created a large fiscal imbalance, which will ultimately be felt in the form of higher interest rates on government debt.
In the end, it’s worth following the Japanese market closely to see how this plays out, but don’t get too excited about the Yen following the same trend.