The Bank of Japan again stunned markets last week. But it wasn't the usual stunner. Far from further easing monetary policy, as investors had widely expected, officials held their fire. After promising for years to do what it takes to push inflation toward 2%, and delivering plenty of easing to make this happen, the BoJ yet again downgraded its forecasts for growth and inflation, but this time decided to stay on hold. The yen, already sharply up in recent months, rallied further. Equity markets tumbled.
The question is why. Most likely, the decision to remain on hold in April was tactical. Monetary officials are often reluctant to give in to investor pressure, preferring occasionally to withhold ammunition and then impart surprise shots for maximum impact.
And then there is the U.S. Federal Reserve. If growth does not buckle in the coming months, officials there may well raise rates over the summer. Timing its next easing move to coincide with the U.S. central bank's tightening would amplify the BoJ's effect on markets. Indeed, shifting the yen's trajectory against the U.S. dollar will prove tough enough, not least given Japan's current account surplus. But it would more easily be accomplished with clear-cut evidence that the two central banks' policies are set on diverging paths. In both June and July, the BoJ holds it policy meetings the day after the Fed's.
Another possibility is that the decision to stay on hold may have been a signal to Japanese Prime Minister Shinzo Abe not to rely overly on monetary policy to reflate the economy, but instead to press on with fiscal consolidation and the reform program. The government, after all, is reportedly considering whether to postpone, if not shelve altogether, next year's planned value-added tax hike from 8% to 10%. The last increase in April 2014 pushed the economy into a recession, and consumer spending has still not recovered all the lost ground.
BoJ Governor Haruhiko Kuroda, a former finance ministry official and fiscal hawk, could have decided to nudge the government toward prudence by withholding further stimulus for the time being. Additional monetary easing may thus follow if the government promises to stick to the planned tax increase.
Other structural reforms, such as greater liberalization of the labor market, have also stalled. The BoJ, presumably, is aware that its actions could temper the sense of urgency for wider economic adjustments. Here, officials face the same dilemma as their peers elsewhere. Monetary easing removes the pressure on politicians to get on with the tough decisions ultimately required to restore economic vibrancy. Arguably, market wobbles are only a small price to pay for this.
Such tactical considerations, however, risk getting in the way of the larger strategic goal. By delaying easing, the central bank is giving the impression that it is nearing the limits of monetary easing, or, at the very least, that officials are no longer determined to do "whatever it takes" to lift inflation. That is a dangerous narrative.
Already, the BoJ's policy options are narrowing. After years of aggressive purchases, officials are running into difficulties buying ever larger quantities of bonds. The government is not issuing these rapidly enough and institutional investors are reluctant to relinquish their existing inventory. The adoption of negative interest rates in January also badly backfired. Not only is the yen up, stocks down, and inflation nowhere closer to the BoJ's goal, but the move shook confidence in a nation of retirees dependent on their savings.
Monetary officials can truthfully argue that it is too early to judge the effect of negative interest rates. Governor Kuroda said that it might take up to a year for the benefits to become apparent. Still, patience with negative interest rates is wearing thin and the BoJ needs to keep public opinion on its side if it is to succeed in raising inflation in a sustainable manner over time.
If expanding bond purchases and pushing rates deeper into negative territory are not feasible, or at least palatable options, what else can the BoJ do? Three things. First, to push the yen lower through outright foreign exchange intervention - not of the conventional kind, but of vast size and financed through freshly printed yen. Second, a massive drop of money into the economy, so-called "helicopter money." Third, risk-asset purchases, namely equity. All of these, on the scale required to make a difference, would take the BoJ deep into unorthodox territory.
Over the next several months, the third option appears most likely, policymakers being less constrained by diplomatic and legal considerations. The bottom line, however, is that something will need to be done. The economy is sinking fast and inflation, even stripping out energy and fresh food as the central bank now prefers, is running at roughly half its target. Sure, extra fiscal stimulus could cushion demand in the near-term, but if the BoJ stands by without easing further, doubts about its determination and ability to push inflation higher would inevitably set in. And that, surely, is a fate that central bankers, whether in Japan or elsewhere, should better avoid.
Frederic Neumann is co-head of Asia Economics Research at HSBC.