This morning the Nikkei index has dropped has much as 6%. By any measure this is an extreme drop in stock prices in one day. Furthermore, we are now officially in bear market territory as the Nikkei is down more than 20% in just three weeks. I can only see one reason for this and one reason only and that is the breakdown of the credibility of Bank of Japan governor Kuroda and his commitment to fulfill his official 2% inflation target.
I would particularly highlight three events for this breakdown of credibility.
First of all I would stress that it seems like the Japanese government has been taken by surprise by the natural increase in bond yields and that is causing officials to question the course of monetary policy. This is Economy Minister Akira Amari commenting on the increase in bond yields on May 19:
“We need to enhance the credibility of government bonds to prevent a rise in long-term yields.”
Second the Minutes from Bank of Japan’s Policy board meeting on April 27 released On May 26 and comments following this week’s monetary policy meeting.
This is from the May 26 Minutes (quoted from MarketWatch):
“Regarding the effects of JGB purchases on liquidity in the JGB and repo market, a few members … expressed the opinion that it should continue to deliberate on measures to prevent a decline in liquidity”
Said in another way some BoJ board members would like the BoJ to try to keep bond yields from rising – hence responding to Mr. Amari’s fears. There is fundamentally only one way of doing this – abandoning the commitment to hit 2% inflation in two years. You can simply not have both – higher inflation and at the same time no increase in bond yields. Bond yields in Japan have been rising exactly because Mr. Kuroda has been successful in initially pushing up inflation expectations. It is that simple.
And third, at the BoJ’s monetary policy announcement this week Bank of Japan governor Kuroda failed to clarify the position of the BoJ and that undoubtedly has unnerved investors further.
Hence, it is important that market turmoil does not reflect a fear of higher nominal bond yields on its own, but rather whether higher bond yields will cause the BoJ to abandon the commitment to increase inflation to 2%.
Therefore what is happening is a completely rational reaction from investors that rightly or wrongly fear that the BoJ is changing course.
As I again and again has stressed Mr. Kuroda can end the market turmoil by first of all stating that the increase nominal bond yields is no worry at all (particularly as real bond yields actually have dropped sharply) and furthermore he should clearly state that the BoJ’s focus is on inflation expectations. Hence, he should state that the BoJ effectively is ‘pegging’ market (breakeven) inflation expectations to 2%. If he did that he would effectively have hindered inflation expectations dropping over the past three weeks. The drop in Japanese inflation expectations in my view is the main cause of the turmoil in global financial markets over the past three weeks.
Should we give Mr. Kuroda a break?
I might be too harsh to Mr. Kuroda here. After all should we really expect everything to be ‘perfect’ at this early stage in the change to the monetary policy regime Japan after 15 years of failure?
This is the alway insightful Mikio Kumada commenting on Linkedin on one of my earlier posts on Japan:
“Lars, give it some time. The regime change at the BOJ is still very new and the ideological shifts in old conservative institutions, with long traditions, such as the BOJ take some time. I think Kuroda made it implicitly clear enough that higher nominal rates are ok as long as real interest rates slump/stay low.”
I think Mikio (who like a lot of market participants, central bankers and monetary policy nerds have join the Global Monetary Policy Network on Linkedin) is on to something here.
We are seeing a revolution at the BoJ so one should not really be surprised that it is not all smoothing sailing. However, on the other hand I am personally very doubtful where we are going next. Will Kuroda effectively be forced by events to abondon his commitment to 2% inflation or will he reaffirm that by becoming much more clear in his communication (don’t worry about higher nominal bond yields and communicate clearly in terms of inflation expectations).
I have my hopes, but I don’t know the answer to this question, but one thing seems clear and that is that nearly everything in the global financial markets – from the value of the South Africa rand, commodity prices and the sentiment in the US stock markets – these days dependent on what Mr. Kuroda does next. Don’t tell me that monetary policy is not important…
PS David Glasner is puzzled by what is going on the US financial markets. I think I just gave the answer above. It is not really Bernanke, but rather Mr. Kuroda David should focus on. At least this time around.