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Japan: On the path to debt monetization – BCA Research

According to BCA Research's Bank Credit Analyst service, current Japanese policies will be insufficient to finally break deflation’s grip. The good news is that policymakers are not without options.

The government will have to postpone the VAT hike scheduled for next year and the Bank of Japan (BoJ) will have to implement one or more of the following policies to end deflation once-and-for-all: adopt an explicit nominal income targeting regime, buy foreign bonds, or monetize government debt. The government has already implemented a type of nominal GDP growth target of 4%, given that it hopes to achieve 2% real growth and 2% inflation in three years. Policymakers could make this target more explicit by promising to keep interest rates at zero and to buy government bonds at a certain pace until private sector forecasts for the level of nominal GDP converge on the BoJ’s target path.

Nominal GDP targeting would be an obvious next step if real yields began to rise and inflation expectations trend lower on a sustained basis, which would be an indication that current policies are failing. Beyond that, buying foreign bonds and debt monetization are possibilities, although both would be politically controversial.

All three policy options would drive up inflation expectations and depress real bond yields across the curve. Debt monetization would be the most potent in terms of boosting inflation expectations, depending on the size of the program. Indeed, monetizing all of the debt held by the central bank could even spark fears of hyper-inflation, although the authorities are unlikely to take it that far.

Buying foreign bonds would lift inflation expectations via a weaker yen and rising import prices. The BoJ already holds foreign assets, so the policy would not be unprecedented. However, Japan’s trading partners might howl in protest. Another problem is that the yen would have to fall continually to keep imported inflation at a high level. The BoJ would also have to maintain aggressive purchases of JGBs to avoid nominal yields from rising too quickly.

That said, these policy options would only be considered after nominal income targeting is attempted, and thus are not near-term concerns for investors.

This post was originally published by the BCA Research blog.

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