Thursday, February 16, 2012

Japan extends asset purchase program: will it work?

The surprise move this week by the Bank of Japan (BoJ) to extend its asset purchase program came just a matter of days after weaker than expected GDP growth for the fourth quarter of last year: the quarterly result came in at an annualized -2.3%, compared with a consensus expectation of -1.4%. The BoJ added ¥10t (US$130b) to their asset purchase program, which will be used to purchase long-dated JGBs.

It's hard to fault the Banks intention: to achieve sustained economic growth under stable prices. Japan has been battling deflation for the last two decades. More recently, the Japanese economy has had to cope with the consequences of the March 2011 earthquake and tsunami and the high Yen which has hit the export sector hard.

So will it work? Quantitative easing (QE) aimed at achieving higher inflation is likely to be more successful than QE aimed at higher employment or stronger economic growth. However, the reality is this increase in the quantum of the program is not likely to be sufficient to have any discernible long-term impact on the exchange rate, or inflation for that matter. Japan is facing larger structural economic (demographic) problems than QE will be able to fix.

In terms of inflation, we think the BoJs adoption this week of a formal inflation target of 1% has the potential to have a more significant impact on longer-term inflation. Inflation expectations are an important determinant of inflation outcomes: the adoption of a formal target helps guide expectations. In New Zealand the setting of an inflation target of 2% in the 1980s was an important factor in the achievement of that goal, and significantly earlier than was originally anticipated.

The BoJs move comes at the same time the European Central Bank is expanding its balance sheet via the provision of unlimited liquidity to the banking sector and just a few days after the Bank of England extended its asset purchase program. The US Federal Reserve is also actively considering a further asset purchase program. Despite its increased use and place as a post-GFC "new normal" central bank policy tool, the success of this approach cannot be fully judged until the cycle is complete, including its eventual withdrawal.