The central bank is struggling with stubbornly low price gains, leaving it with little flexibility in pursuing monetary policy options.

Japan has been on a long holiday. The annual Golden Week was extended because Emperor Akihito abdicated in favor of his son, Naruhito. With a new emperor comes a new era: Reiwa, the era of "beautiful harmony," according to the official translation. The timing of the holiday has affected data flow. Japanese demand for vacation packages surged ahead of the unprecedented 10-day holiday, pushing up the prices and core inflation. While the jump in inflation was striking, we do not believe it has any lasting implications. Core inflation is likely to fall quite sharply over the summer months because mobile telephone charges are set to drop in the near future.

The Bank of Japan (BoJ) held its April meeting just before the long holiday began. The meeting came against a backdrop of weaker economic data and increasing commentary in the markets about the adverse effect on the financial system from holding interest rates at low levels for so long. This meeting also saw the publication of the BoJ's forecasts for 2021.

The persistence of below-target inflation and concerns about the adverse consequences of existing policy pose a problem for the BoJ.

The central bank said that core consumer price gains will average no better than 1.6% until at least the fiscal year ending in March 2022. That is well below the 2% target and is hardly consistent with the BoJ's pledge to overshoot the target to rebuild confidence in its ability to achieve that target. But the persistence of below-target inflation and concerns about the adverse consequences of existing policy pose a problem for the BoJ.

Policy doubts increase

In the past, BoJ Governor Haruhiko Kuroda stressed the importance of expectations in determining inflation. His initial policy measures were designed to shock inflation expectations higher. But these measures clearly did not succeed. The longer the BoJ persists with an unchanged policy stance despite projecting below-target inflation, the less likely it seems that expectations will move higher.

Reluctant to admit it is stuck, the BoJ did at least make a couple of tweaks to its policy stance. It adjusted the terms and conditions on which it lends to banks. Collateral requirements were eased across a range of the BoJ's lending programs, measures designed to help the profitability of lending by commercial banks despite the BoJ policy of controlling the yield curve. It also created an ETF lending facility. The facility allows the BoJ to offset, at least in part, the impact on market liquidity of its very high levels of ownership of a range of ETFs. All of these measures can be interpreted as attempts by the central bank to minimize the adverse effects on the financial sector of current policy.

Japan's inflation trends

Sowing seeds of confusion

The BoJ also introduced new guidance on its rate policy. The central bank left its key monetary settings unchanged in April, but changed the wording of its "forward guidance." It had previously pledged to hold rates at the current level for an "extended period" that was vaguely linked to a sales-tax hike set for October. It now says interest rates will be on hold until at least the spring of 2020. This new policy does not differ much from the previous pledges to keep rates unchanged for an "extended period of time" and until after the effects of the scheduled October 2019 tax hike had passed. We interpreted this to mean at least six months after October, which brings us to the spring of 2020.

The reality is that the BoJ is out of substantive options.

We can interpret the change in the forward guidance several ways. The calendar guidance tool can be extended, and it is possible this could be used to loosen the central bank's monetary policy stance. And it would allow the BoJ to reduce its Japanese government bonds (JGBs) without creating expectations for a hike in the policy rate. These are very fine points. The reality is that the BoJ is out of substantive options. The BoJ wanted to keep pace with the dovish stance of other global central banks. Many policy makers from Europe to Asia have paused interest-rate hikes or turned dovish again. As mentioned earlier, the Fed signaled it won't hike interest rates for a while, while the ECB offered fresh stimulus. But there is not a lot the BoJ can do. It will be in a difficult position when the next global downturn hits.


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