Mr. Kuroda please ‘peg’ inflation expectations to 2% now

Bank of Japan governor Kuroda came off to a good start when he announced his strategy for taking Japan out of 15 years in the beginning of April – the yen weakened, the Nikkei rallied and most importantly inflation expectations started to inch up. However, over the past two weeks Mr. Kuroda’s efforts have run into trouble. The Nikkei has tumbled and fears that Mr. Kuroda will not be able to deliver on his promise to increase Japanese inflation to 2% have increased.

The best way to measure of the the erosion of Mr. Kuroda’s credibility over the past two weeks is market expectations for inflation. The graph below shows 5-year market expectations for Japanese inflation.

5-year inflation expectations japan

The picture is very clear. Initially Mr. Kuroda was very successful in pushing up inflation expectation. However, the picture also very clearly shows that over the last two weeks inflation expectations have declined worryingly fast.

If you want to find a reason for the sell-off in the Nikkei you need to look no further than this graph. As the markets have been loosing faith in Mr. Kuroda commitment to ending deflation the Nikkei has plummeted.

I believe the the main reason for the recent drop in Japanese inflation has to be blamed on BoJ’s clumsy handling of the fact the Japanese bond yields have started to rise.

Hence, comments from Bank of Japan officials – including Mr. Kuroda – indicates that BoJ is trying to achieve the impossible – monetary easing without higher nominal bond yields. That is creating the confusion about the BoJ’s objectives, which have caused inflation expectations to plummet.

Anybody who have ever read Milton Friedman would of course know that when you ease monetary policy you should expect nominal bond yields to rise as inflation expectations pick up. In fact higher nominal bond yields is a very clear sign that you successfully have increased market expectations of future inflation.

The Bank of Japan’s efforts to get Japan out of deflation will be doomed if the BoJ continues to express concern about the rise in nominal bond yields. Hence, if future monetary easing is made conditional on keeping bond yield low then Japan will surely remain in deflation.

Think of 2% inflation expectations as a fixed exchange rate policy

I therefore think it is about time the that BoJ stop worrying about bond yields and instead focus 100% on market expectations for future inflation. Last week I suggest that Mr. Kuroda put out the following statement (and a bit more):

“…So while inflation expectations have increased they are still far below our 2% inflation target on all relevant time horizons. We therefore stand ready if necessary to further step up the monthly increase in the money base. We will evaluate that need based on market expectations of future inflation.

We will particularly focus on market pricing of 2year/2year and 5year/5year break-even inflation expectations. We want investors to understand that we will ensure that market pricing fully reflects our inflation target. That means 2% inflation expectations on all relevant time horizons. No less, no more.”

Said in another way the Bank of Japan should basically “peg” market expectations for future inflation to 2%. The best way to think of this would be to think of the inflation target as for of a fixed exchange rate.

In the same way a central bank that operates a fixed exchange rate policy promises to buy or sell a currency at given exchange rate the BoJ should basically promise to buy or sell inflation-linked Japanese government bonds so to ensure that the market expectations will also be 2% on all time relevant time horizons.

Lets illustrate that in a AS-AD model (are you watching Peter Dorman?). Imagine that we in the starting point already has inflation expectations at 2%. Now a negative shock hits aggregate demand – the Japanese government for example cuts public spending by 10%. That shifts the AD curve to the left.

inflation target BoJ ASAD

A negative AD shock will initially push inflation below 2% (to p’ in the graph).

However, if the BoJ would be operating an exchange rate style inflation targeting regime the drop in market inflation expectations would cause the BoJ to step up buying of inflation-linked bonds. That would of course lead to an ‘automatic’ increase in the Japanese money base while at the same time push back inflation expectations to 2%.

This would obviously also mean that what we have seen in the Japanese markets over the past two week would not have happened.

In fact the BoJ would not really need to communicate about anything other than again and again repeating that is will do what ever it takes to keep market expectations ‘pegged’ at 2%. The policy would be fully automatic and Mr. Kuroda could spend most of his time golfing. In fact as the policy would become recognized by the markets the BoJ would likely have to do very little actual selling and buying of bonds.

Hence, central banks with credible exchange rate pegs – like the Danish central bank or the Hong Kong Monetary Authority actually do very little actual intervention in the FX markets as market expectations will take care of most of the work. Similar if the BoJ tomorrow would announced what I have just suggested then market expectations for future inflation would like imitatively jump up to 2% and stay there. Initially the BoJ would have to support this policy by increasing the money base, but I fundamentally think that the need for future QE would fast disappear.

It is of course notable that under such a regime monetary conditions would automatically shift in response to different shocks to aggregate demand – weaker Chinese growth, renewed euro zone troubles, scaling back of QE in the US, global financial distress, fiscal tightening in Japan etc.

Mr. Kuroda it is very simple – all you need to do to end the erosion of your credibility is to ‘peg’ inflation expectations to 2% right now. The longer you wait the more likely it is that you will fail to take Japan out of deflation.

Leave a comment


  1. “I believe the the main reason for the recent drop in Japanese inflation has to be blamed on BoJ’s clumsy handling of the fact the Japanese bond yields have started to rise.”

    Very clumsy! But Fed isnt better with al the “tapering” talk…. I dont understand these people. Dont they have a certain target? Why complicate, talk about exit when you hit the target -_-.

  2. Ravi

     /  June 5, 2013

    Petar – spot on, I was just going to say the same thing about the Fed!

  3. Francois Poullet

     /  June 8, 2013

    A technical question about Japanese inflation breakevens. I am wondering whether these inflation breakevens include the impact of the planned sales tax increases or not. If yes, then the increase of the 5Y breakevens is woefully insufficient. The current level of the 5Y breakevens would still imply true inflation close to zero. Any opinion about that?

    • Francois,

      That is a highly relevant question. In data in my graph is not corrected for the impact of the sales tax highs and you are therefore right – we are still very far away from the monetary policy easing being credible.

      This is also the reason that I argue that Kuroda should focus on 2y/2y or 5y/5y inflation – hence the inflation expectation for inflation in two (five) years and two (five) years ahead. These expectations are still well below 1%.

  4. Eske Traberg Smidt

     /  June 11, 2013

    Hej Lars,

    Hvad tnker du om denne artikel?


    Sendt fra min iPhone

    Den 04/06/2013 kl. 07.51 skrev The Market Monetarist : Lars Christensen posted: “Bank of Japan governor Kuroda came off to a good start when he announced his strategy for taking Japan out of 15 years in the beginning of April – the yen weakened, the Nikkei rallied and most importantly inflation expectations started to inch up. However”

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