After Japan’s Prime Minister Shinzo Abe reshuffled his Cabinet on 3 August, the big question is whether his administration can regain public support. In just the last two months, Abe's public approval ratings have plunged to around 30% – low enough to raise red flags.
Financial markets have been calm despite the rapid rise in political uncertainty. Are they right or are they complacent?
Easy monetary policy calms Japan’s financial markets
Risk assets in general have continued to perform quite well in Japan. For instance, the TOPIX index has returned 4.2% since the end of May, outperforming the S&P 500's 2.5% rise.
Why so little negative reaction to rising political uncertainty in Japan? The popular argument has four main points:
- No general election is scheduled until the current term for the Lower House ends in December 2018.
- Even if Prime Minister Abe were to continue losing popularity and be replaced by someone before the scheduled party presidential election in September 2018, his successor would most likely be chosen from the current Abe Cabinet or his close allies.
- “Abenomics,” therefore, would stay with us, and importantly, its most powerful aspect – extraordinary monetary policy easing – would remain unchanged.
- In addition, Japan’s domestic economic policy aside, the global economy is in good shape, with solid growth.
We think these arguments are too optimistic.
Structural reform still lacking
The Bank of Japan’s (BOJ) four years of extraordinary monetary easing have no doubt had positive economic effects. The job market is quite strong, with the unemployment rate falling to 2.8% in June 2017.
But the tighter output gap has not translated into inflation, which remains near zero and far from the BOJ’s 2% target. As the BOJ’s current policy nears its limit, the experience has ironically proved skeptics’ hypothesis that monetary policy alone cannot end Japan’s two decades of deflation: Japan also needs sound policies to address structural problems.
What are the structural problems that need to be resolved? Precautionary saving will likely continue to weigh on household consumption growth unless social security reforms address people’s concerns about retirement in the world’s fastest-aging society. Wage growth will remain depressed despite the tightening in the job market unless labor market reforms transform Japan’s customary seniority-based compensation system to a merit-based one, and labor mobility increases.
Long-term positive structural reforms were expected to come as the “third arrow” of Abenomics, which was introduced nearly five years ago. However, sound reforms, which would have deflationary impacts in the near term, seem unlikely now that the Abe administration’s political capital has been depleted.
Potential impact of politics on Japan’s monetary policy
The increase in political uncertainty could also affect the BOJ’s monetary policy going forward. The policy sequence of Abenomics was expected to unfold in a certain way: Monetary and fiscal policies would stimulate demand, and then structural policies would follow to raise supply-side potential.
The demand stimulus was meant to offset any near-term deflationary impact, or pain, brought about by supply-side policy. However, if long-term effective structural policies are now even more unlikely (since political capital has been depleted), it may be harder to justify continuing extraordinarily easy monetary policy, considering its side effects.
As the BOJ admitted in the self-assessment of its quantitative easing program in September 2016, excessively low yields and a flat bond yield curve have economic costs over time. Importantly, they can adversely affect financial institutions’ profitability and hence damage financial intermediation. In addition, the BOJ’s purchase of Japanese equity ETFs, which is extraordinary in size (¥6 trillion, or $54 billion per year), is distorting market functioning.
The effects of political instability on BOJ policy could potentially be quite large if it leads to Prime Minister Abe being replaced by someone who seeks less aggressive policy stimulus and accordingly replaces BOJ Governor Haruhiko Kuroda, whose current term expires next spring. While still a low-probability scenario, it seems higher today than a few months ago.
Studies have shown that people tend to underappreciate new information that is unfavorable to their opinion or positioning, and they tend to extrapolate past or present experience into the future. As this relates to Japan, investors have probably become too used to extraordinary reflationary policy stimulus.
As political uncertainty rises, we think caution is warranted on Japan, particularly because risk-asset valuations are generally quite elevated. For investors, it's not the time for complacency.
A version of this article appeared in Japanese in The Nikkei on 4 August 2017.
Tomoya Masanao is co-head of Asia portfolio management at PIMCO in Tokyo.
For more of our views on central bank policy, read “The Fed Balance Sheet and the Taper Tantrum That Ain’t (Yet)”