March 30, 2017 5:30 am JST
BOJ watch

Japan's central bank losing headroom on the yen

Erosion of 10 yen buffer threatens to sap reflationary efforts

MASAYUKI YUDA, Nikkei staff writer

The Bank of Japan's headquarters in Tokyo.

TOKYO -- The yen has picked up strength to a level not seen in roughly four months, seemingly putting the Bank of Japan's 2% inflation target in jeopardy. Although the central bank is not yet in panic mode, the situation leaves little room for optimism.

This week, the Japanese currency advanced into the 110 yen range against the dollar. Ever since Donald Trump's victory in the U.S. presidential election in November, a weakening yen has propped up export-heavy Japanese firms and corporate earnings, giving the inflation goal a new lease on life. But now that dynamic is heading in the other direction.

Before the two-day policy meeting that ended March 16, multiple senior BOJ officials exuded confidence, maintaining that there is still a 10 yen cushion despite the Japanese currency trending stronger. Indeed, the exchange rate at that point was hovering more than 10 yen weaker than the 101.19 recorded on the day of the U.S. presidential election.

The BOJ employs two mechanisms to fan the monetary easing effects. One is guiding interest rates lower to support funding and investment demands by corporations. The other is keeping interest rates lower than peers overseas so that global funds will more likely migrate away from the yen toward higher-yielding assets, thereby creating an environment favorable for a cheap yen.

But whether the yen actually softens depends heavily on international yields. Even if the BOJ successfully tamps down domestic interest rates, that would not matter much if rates in other economies fail to increase. The rate spread would not widen, and the capital outflow from the yen would lose momentum.

It is this international factor that is putting the squeeze on the BOJ's 10 yen buffer. In the U.S., Trump's push to repeal and replace the Affordable Care Act, also known as Obamacare, suffered a major setback last week when Congress was unable to compromise on substitute legislation. That defeat now clouds Trump's other signature agendas, such as tax cuts and massive infrastructure spending, sending long-term Treasury yields lower and shrinking the U.S.-Japan rate spread.

In addition, there are other international events in the coming weeks worthy of elevated concern, such as the French presidential election. That does not bode well for other Japanese rate margins, which may further fuel the upward march of the yen.

Right now, the BOJ does not appear to be in a state of alarm. Officials have made their peace with the fact that key indicators are at the mercy of international trends, and they are prepared to deal with those tendencies soberly by employing rate controls.

That said, there is no denying that the recent surge of the yen is nothing to celebrate. Japan is approaching the peak of spring labor talks, and the hope is that wages will rise significantly to put upward pressure on consumption and consumer prices.

But "with material uncertainties affecting international factors, companies are not weakening their cautious stances toward increases in base pay, which are associated with added fixed costs," said one BOJ member at this month's policy meeting.

If the yen appreciation leads to misgivings about Japanese corporate earnings, business managers might think more about retaining those earnings instead of immediately putting those funds to use elsewhere. In order to promote a healthy economic cycle that contributes to a stable inflation rate, ample vigilance at this stage is highly recommended.

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