Japan can continue QE as inflation remains below 2% - Nomura

According to Richard Koo, chief economist at Nomura, while central banks in Europe and the US are moving to normalize monetary policy long before inflation reaches the 2% target level, the Bank of Japan continues to doggedly implement monetary accommodation in the hope of attaining the 2% price target even though the economy is already at full employment and is characterized by mini-bubbles and labor shortages.

Key Quotes

“Balance sheet problems and the fact that Japan is a pursued economy with lower returns on capital than are available overseas have created a situation in which there are no borrowers. Under such conditions, reckless easing by the central bank does no good and has the potential to do a great deal of harm. For the moment, however, the adverse side effects of the policy have yet to materialize to a significant degree.”

“Although pensioners and financial institutions have suffered greatly under negative interest rates, it is paradoxically because inflation has yet to reach the 2% target that the economy is relatively strong and the BOJ can leave its policies in place.”

“No reason why 2% inflation should improve Japan’s economy

• If Japan had already achieved 2% inflation, the financial markets would probably be in deep trouble, facing the risk of a crash in the JGB market. Many hedge funds plan to begin shorting JGBs once inflation hits 2% and the BOJ is unable to buy any more government bonds.
• At that point in time the BOJ will also have to reverse its course to absorb the excess reserves in the market in order to prevent a further acceleration of inflation. The amount of bonds that must be sold to undo its QE will be five times greater as a percentage of GDP than in the US or the eurozone and three times greater than in the UK.
• Moreover, there is no reason why a 2% inflation rate should produce dramatic improvements in an economy that is already at full employment. If anything, domestic inflation and rising costs are likely to prompt more Japanese businesses to invest overseas to maintain their competitiveness.
• In summary, the return of inflation in an economy that is already at full employment would not only have no benefits, but would entail a number of severe risks, including a crash in the bond market and a corresponding fiscal crisis.”