Why Bank of Japan does not hike rates?

Every time the Bank of Japan (BOJ) continues its aggressive monetary easing, the common reaction is one of disbelief: “What are they thinking?” Especially as inflation climbed and central banks all around the world aggressively raised the rates, it seemed straightforward to question the BOJ’s approach. However, the final speech of Uchida Shinichi, thoroughly clarifies the strategy behind their decisions, offering (in my view) a comprehensive explanation for the BOJ’s persistent dovish stance. While there’s room to challenge various arguments presented by Shinichi, the overall explanation is presented in a clear and convincing manner.

  • Japans’s approach to monetary policy is less reactionary due to a complex array of structural challenges. The nation faces a longstanding battle against deflation, demographic issues, and a significantly low natural interest rate, making it impractical to automatically raise interest rates while there is a rising inflation.
  • The historical context significantly influences Japan’s monetary policy, setting it apart from the economic landscape of the United States and Europe.
  • Unlike other central banks that were wary of wage-price spirals in 2021/2022, BOJ sees value in these dynamics. In Japan, labor shortages and increasing wages are viewed as critical tools for moving the economy beyond the stagnation caused by firms dependent on unhanging wages and static workforce.
  • The BOJ’s policy devisions consider a broad range of technical and market factors, rendering the simplistic approach of hiking rates in response to inflation increases unsuitable for Japan. The strategy encompasses a more comprehensive and intricate perspective.

Positive interaction between Salaries and Costs

Looking ahead, the BOJ intends to closely track the positive interaction between salaries and costs by thoroughly analyzing a variety of data and insights. Should the sustainable and stable reach of the 2 percent inflation goal appear achievable, it would indicate that the extensive monetary easing policy has served its intended purpose, prompting a review for possible adjustments. This policy has been active for over a decade, underscoring the importance of careful planning in both communication strategies and market operations to ensure a seamless transition in financial markets around any policy adjustments. Consequently, it’s crucial for the Bank to transparently share its rationale behind any potential changes to specific policies, to the extent feasible.

Interest rate policy framework

The Bank’s core strategy involves assessing the present and future prospects of economic activity and inflation to adjust the policy interest rate suitably, aiming to align closely with a 2 percent CPI inflation target. The eventual direction will be influenced by upcoming economic and inflationary trends. Despite this, based on the previously discussed outlook, ending the negative interest rate policy does not necessarily lead to a swift increase in interest rates. It’s anticipated that the Bank would continue to support a supportive financial environment, even following the potential end of the negative interest rate policy.

Navigating Business Operations Amid Labor Shortages

In this context, we’re beginning to uncover a potential solution to enhancing Japan’s growth capacity. While labor shortages present challenges for businesses, they also offer a silver lining. These shortages can catalyze the transformation of companies and boost the economy’s overall efficiency, as seen from the perspective of the workforce. This happens as businesses are motivated to develop sustainable profit models that support ongoing wage increases and to strive more actively to attract employees.

However, in the competitive landscape of capitalism, not every firm will thrive. The concept of “economic metabolism” often carries positive undertones and might be used somewhat lightly, but it inherently involves a tough truth: it necessitates the departure of some businesses from the market.

Some businesses might nostalgically recall the deflationary era, which permitted survival without aggressive expansion. Yet, without this kind of economic vitality, Japan cannot hope to rejuvenate its growth potential, especially against the backdrop of a shrinking population. Thus, a practical approach would be to foster this economic renewal while minimizing transitional costs. Labor shortage-driven economic metabolism has the advantage of relatively low transition costs since it’s less likely to lead to unemployment. However, it’s important to acknowledge that not all displaced workers will immediately secure new employment, indicating that this process, while beneficial, is not without its hardships.

Encouragingly, there’s a growing trend of companies engaging in mergers and acquisitions or business successions, drawn by the talent within the firms they acquire. This strategy represents a positive development in managing the challenges and opportunities presented by labor shortages.

Standard Practices in the Era of Deflation

During Japan’s shift away from deflation, the prevailing social norms and behaviors, which anticipated stagnant wages and prices, have constrained corporate strategy. Companies found it challenging to innovate or adjust their pricing upwards under the weight of these deflationary expectations. The precise mechanisms through which these norms have negatively impacted the economy remain somewhat ambiguous. Theoretically, changes in the relative prices of specific products should be feasible, irrespective of the general rate of inflation. For further illustration, refer to Chart 14.

One argument suggests that changing the current mindset could simplify wage adjustments for companies. Presently, firms often prefer one-time payments over increasing base wages due to concerns about rising fixed costs, a mentality rooted in expectations of deflation or no inflation. However, in economies experiencing consistent inflation around 2% annually, such as Europe, the United States, and Japan during the 1980s, companies can afford to raise base pay without the burden of increased fixed costs, adjusting future wage increases accordingly.

Moreover, with nominal wages rising annually, companies could have the flexibility to adjust wages based on their performance or to attract specific talents, offering a strategic advantage in shifting from deflationary norms. Yet, this shift alone might not be transformative for society. The deflationary era’s narrative, focusing on stagnant wages and prices, overlooks the deeper economic, social, and political factors at play, including intense competition, demand shortages, employment concerns, and safety nets that allowed companies to survive without wage increases.

For over a decade, despite the end of deflation, Japan struggled to move beyond these norms, primarily due to the delayed emergence of a genuine labor shortage economy. Now, with wages beginning to rise, partly due to cost-push factors from abroad, Japan is poised for economic change, breaking free from deflationary attitudes towards a model where wages and prices can grow, potentially unlocking greater economic potential.

The Bank of Japan aims to support this transition through stable and supportive monetary policies, emphasizing that positive interest rates can’t be achieved solely by raising rates but require overall economic and price improvements.

This dovish stance underscores the Bank’s continued commitment to substantial monetary support, indicating no rush to change course. However, the USD/JPY dynamic remains more influenced by US rates than by BOJ policies. Recent observations suggest that, unlike previous instances, the Ministry of Finance may not intervene at the 152 level, considering the current economic indicators, the adaptability to a weaker yen, and the lack of immediate concerns such as oil prices or inflation. This stance is informed by a historical approach that weighs both the speed and level of currency changes, suggesting a new threshold for potential intervention which is 162 presently.

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