BoJ shocks markets; how about the economy?

Based on the current USD/JPY rate and drop in oil prices, we see core CPI inflation (ex-VAT hike effects) trending below 1% y/y from October onward. Our baseline scenario for the economy assumes the VAT hike planned for October 2015 (to 10% from 8%) will be approved in December, along with a JPY4-5trn supplementary budget.

The latest BoJ action should facilitate passage of the hike.In taking its actions, the BoJ cited “somewhat weak developments in demand following the consumption tax hike,” along with a “substantial decline in crude oil prices” and the risk that it might lead to a delay in the “conversion of deflationary mindset.” Few would disagree with this assessment. Prior to the MPM, however, it appeared that the BoJ was reluctant to acknowledge the slump in inflation expectations or to treat the two-year horizon for achieving its 2% y/y CPI price stability target as a hard deadline that might require further easing.

At the 6-7 October MPM, for example, only one of the nine Policy Board members objected to the language that “inflation expectations appear to be rising on the whole” despite evidence to the contrary (Figure 3). Also, just three days prior to the 31 October MPM, BoJ Governor Kuroda reiterated in parliament that “the CPI will likely trend around 1.25% y/y for now, then head up again from the second half of the fiscal year, reaching the price stability target of 2% around the middle of the FY14-16 forecast period” and that “QQE has exhibited the intended effects and the economy is moving smoothly along the path to realizing the 2% price stability target.”

Prior to the latest MPM, the BoJ discontinued its reference to achieving the 2% target in “two years” (language it used when introducing QQE in April 2013) in favour of “in and around FY15.” This shift appeared to be aimed at sustaining inflation expectations over roughly the same horizon, while also signalling to the markets that the BoJ would not feel compelled to ease based narrowly on the outlook for prices in April 2015.

In this context, we expected the BoJ to focus on forward guidance, officially dropping the “two-year” time horizon for achieving its price stability target and shifting to purely state-dependent forward guidance (continuing with QQE until CPI inflation stabilizes at 2%, without new calendar-based targets for the monetary base beyond end-2014). It did that, but also eased.

Interestingly, however, the BoJ’s updated forecasts, published as part of the semi-annual Outlook Report, approached consensus for real GDP growth but remained relatively bullish for core CPI inflation, especially from FY15 onward.