Stopping deflation has been the most important macroeconomic policy target for Japan for more than 15 years. Japan’s nominal GDP was its highest level of 523 trillion yen in 1997 and had been declining to 472 trillion yen in 2011, one year before Abenomics, macroeconomic policies under Abe cabinet, was launched. The Japanese economy was stuck in a deflationary cycle for many years. Very aggressive monetary policy under Abenomics was effective to change the deflationary trend. Nominal GDP started rising since 2012 and it reached the level 532 trillion yen in 2015 (under revised method to calculate GDP data). Abenomics was effective to stop the country’s deflationary trend. However, it was not effective enough to achieve the two percent inflation target set by The Bank of Japan (BOJ). The international economic environment such as weak export demand, the appreciating trend of the yen and the decrease of energy prices were operating against the BOJ policy. The Japanese government shifted to a more aggressive fiscal stimulation to compensate for the weakening influence of monetary policy. Macroeconomic trends suddenly changed after the presidential elections in the United States in November. Long-term interest rates of major countries started rising drastically after the election. This change reflects market anticipation of the changing pattern of US macroeconomic policies from very low interest rates and restrictive fiscal policy to expansionary fiscal policy and raising interest rates.
For Japan, the ‘Trump shock’ implies the depreciation of the yen, rising stock prices and rising long-term interest rates. The Yen-dollar exchange rate depreciated from 102 to 117 in a month and the Nikkei stock price index rose by about 15 % during the same period. Although there remains various uncertainty about the economic policies under a U.S. President Trump, Japan is for now taking advantage of a changing international economic environment. It is noteworthy that fiscal expansion and monetary tightening in the United States both provide expansionary effects to the Japanese economy.
Attention should be assigned to the trend of long-run interest and exchange rates. In the first two weeks after the U.S. elections, the 10-year government bond rate in the U.S. rose from 1.85 to 2.35, that of Japan rose from – 0.07 to 0.07. Indeed, the interest rate gap between the two countries has widened. The depreciation of yen can be explained by this interest rate gap. The BOJ announced in September 2016 to seek to maintain the 10-year government bond rate at around 0%. The rising trend of long-term interest rate in the major countries, which gave upward pressure on the long-term interest rate in Japan, made the BOJ increase its bond purchases in order to keep the interest rate lower. The question now is whether the BOJ will be able to maintain the zero percent target for government bonds against the background of a further rise of interest rates in the U.S. The wider the gap in interest rate between the two countries is, the cheaper will be the yen-dollar exchange rate. While this trend is favorable fighting and stopping deflation, too much depreciation of the yen could cause policy frictions. The markets are obviously keen to find out whether the BOJ will stick with the zero percent interest rates or will in the future allow higher interest rates. The BOJ will need to turn to more substantial market intervention, such as increasing the purchase of government bonds, in order to be able to continue its zero interest rate if and when US interest rates continue to rise. If the zero percent target is achieved, the yen will depreciate more in the face of rising U.S. interest rates. Higher U.S. interest rate thus give the BOJ more space to choose between higher interest rate and a cheaper yen-dollar exchange rate.
Motoshige Itoh, Gakushuin University and Member of Council on Fiscal and Economic Policy