25 July 2017
Four years into the Abenomics project, much has been achieved. Inflation has averaged 0.7% year-on-year (y/y), compared to -0.2% y/y in the previous decade; the primary deficit has been halved; and governance and taxation policies have been reformed. However, policy momentum has slowed, and is in danger of grinding to a halt. This risks undermining policy credibility, making the task of exiting its lost decades more difficult. Here we consider the steps needed to get Abenomics back on track.
Last week’s monetary policy meeting highlighted the inertia of current monetary policy. Despite the Bank revising down its inflation forecast in each of the next three years, no remedial action was taken. In reality, few expected anything else. A survey of 42 economists taken prior to the meeting revealed not one was willing to bet on any change in policy. Worse still, 26 of the 42 surveyed considered the Bank’s inaction a dereliction of duty as they do not envisage inflation ever exceeding 2% in a stable manner. We have repeatedly stated that the Bank’s communication policy should help shape private sector expectations, assisting in the central bank’s ability to meet its monetary policy objectives. The hodgepodge analysis of the Comprehensive Assessment and the weakness of debate within the policy board, not to mention the reluctance to talk about future policy direction have weakened the BOJ’s already poor credibility. For that reason, we agree with Etsuro Honda that a ‘fresh face’ is needed at the Bank. A decision on a new Governor is expected later this year. And Prime Minister Abe will need to choose someone capable of revamping the Bank’s communications policy and restoring credibility to its price projections.
The second major question for Abe is what to do about the almost inevitable missing of its FY2020 target to eliminate the fiscal deficit. Last week’s publication of the Cabinet Office’s projections revealed the primary deficit is expected to remain negative in 2020 (see Chart 7). This reflects a slight deterioration on previous estimates given lower tax revenues from a weaker nominal growth outlook. However, even with more spending cuts, the current approach looks doomed to failure. This has raised the prospect of a shift in the fiscal consolidation framework. What are the options here? The credibility of the government’s fiscal projections rests on 1) the annual pace of fiscal consolidation 2) the gap between the nominal interest rate and growth rate. Fiscal projections typically assume a long-run average for the gap - in Japan’s case 2%. However, if the gap is zero or negative then the fiscal consolidation path will be shallower. Given the government’s long-term borrowing costs are currently pegged by the Bank at low levels, a pro-growth fiscal policy might serve to reduce the stock of debt even if elimination of the fiscal balance is delayed. Of course, there is a risk that government spending fails to generate sufficient growth, undermining fiscal stability in the longer term. However, such an outcome seems unlikely as long as the Bank retains control of borrowing costs. A final consideration for Abe is how to respond to the recent slump in his approval rating (see Chart 8). So far Abe has taken comfort from the fact his support has not migrated to opposition parties. However, a more proactive approach may be required if he is to restore his authority and take the bold decisions required to revitalise the economic project that bears his name.