Macro Signposts | 14 May 2024

This week, I asked Tomoya Masanao to coauthor Macro Signposts, assessing Japan's fiscal trajectory under the new scenario for 2% inflation. Tomoya is co-head of Asia-Pacific portfolio management, and co-head of PIMCO Japan.

Unless explicitly stated, views expressed do not constitute official PIMCO views.

Japan: Could 2% Inflation Create an Unstable Equilibrium?

By Tiffany Wilding and Tomoya Masanao

On the surface, Japan's recent strides toward monetary policy normalization all appear to be good news. The Bank of Japan (BOJ) in March ended its negative interest rate policy that had prevailed for the past eight years. Underlying price and wage inflation finally appear more consistent with the central bank's long-held 2% inflation goal. Importantly, inflation expectations have also moved higher. It appears Japan finally might be exiting decades of low and negative inflation.

However, a closer look suggests that moving from a generally stable state of low rates and inflation to an economy of 2% inflation could also uncover vulnerabilities that increase volatility. A closer look at Japan's underlying debt and deposit dynamics helps illustrate why.

A complicated public sector balance sheet ...
At over 230%, Japan has the highest central government debt-to-GDP ratio across developed market (DM) economies, far surpassing those of Italy (roughly 140%) and the U.S. (120%), according to the International Monetary Fund (IMF). In fact, Japan's low and stable interest rates despite elevated debt levels have made it the centerpiece of arguments, especially in the U.S., that high and rising government debt shouldn't be a cause for concern (the Congressional Budget Office projects U.S. government debt could reach 200% of GDP over the next few decades).

However, a more comprehensive analysis of Japan's consolidated public sector balance sheet reveals key insights into why Japan has been able to maintain elevated government debt, and why vulnerabilities could potentially arise.

According to Japanese flow of funds accounts data, the public sector's net liability position is roughly 120% of GDP – in line with the U.S., and much less than Japan's headline debt-to-GDP figure. Two key factors drive the difference between headline government debt and the consolidated net liability position.

First, a consolidated balance sheet captures intergovernmental holdings, including the BOJ's holdings of Japanese government bonds (JGBs) – equivalent to roughly 100% of GDP – that are backed by banking sector deposits.

Second, the net liability position also captures the cumulative operating surpluses or deficits of independent agencies. That includes Japan's social security fund, which holds a sizable (55% of GDP) net asset position, including domestic and foreign equities and bonds.

Through the BOJ's swapping of JGBs for deposits, the net result of Japan's public sector balance sheet has been households lending to the Japanese government at (until recently) negative rates, and the government investing a good portion of that money (roughly 130% of GDP, according to the flow of funds accounts) into riskier domestic and foreign assets offering much higher rates. This maturity mismatch has yielded Japan's government a decent net return over the years.

... creates potential vulnerabilities
Over the past several decades, Japanese households have been willing to hold a large portion of their wealth – around 50%, according to the flow of funds accounts – in bank deposits at negative yields, because real rates on those assets were boosted by flat to falling prices in Japan. Now that rising inflation is significantly reducing those real rates, Japanese households have an incentive to allocate elsewhere, including riskier domestic and foreign securities.

Should these capital flows materialize in a significant way, they could potentially weaken the yen. Remember that only the government and banks can create and extinguish nominal deposits in the banking system. So when one Japanese household wants to move money from bank deposits into higher-yielding foreign bonds, for example, some other agent must to be willing to take on those negative-yielding deposits. They may not be willing unless the yen weakens further.

Since a weaker yen makes foreign goods more expensive, it would in turn support inflation, which could lead to higher interest rates. While higher rates would be good for Japanese household savers, they could be problematic for the government's roughly 110% net public sector liability position. Government debt becomes unsustainable when nominal interest rates rise above nominal growth (when "r" is greater than "g," in the parlance of economists).

And herein lies the vulnerability: There is a risk scenario in which a vicious cycle of currency depreciation and inflation necessitates higher interest rates. And if investors demand higher term premiums to compensate them for additional interest rate risk, then r could rise above g, creating vulnerabilities for public finances. (For more, read the recent PIMCO Perspectives on term premium.)

Of course, this scenario is by no means assured. The good news is that the majority of Japanese deposits are held by retirees, who tend to have low risk tolerance. The public sector's large stock of foreign assets could be repatriated if the yen were to weaken aggressively. Also, over the years, the BOJ has demonstrated its willingness and ability to manage interest rates in the Japanese economy; investors' recognition that the BOJ stands ready to intervene should help contain interest rate volatility. Furthermore, Japanese nominal trend growth of 2.5% (the real growth trend rate of 0.5% plus the 2% inflation target) is still well above longer-term Japanese bond yields (as of this writing, the 5-year, 5-year-forward JGB was trading at 1.35%), meaning Japanese rates would have to rise significantly, and say there, to put pressure on the government.

What can policymakers do?
The scenario described above is a risk scenario, but markets appear to be actively pricing this risk – so policymakers may want to consider mitigation strategies. One obvious course of action is to pare some fiscal adjustment. Luckily, Japan has the economic capacity for orthodox fiscal policies, including raising taxes, to help reduce government deficits.

At roughly 35%, Japan's government revenues as a percentage of GDP are the smallest of any major developed economy except the U.S. (about 30%), according to IMF data. The IMF also projects Japan will have one of the largest fiscal consolidations of the DM economies over the next several years, shrinking deficits by an estimated 3 percentage points. To be sure, this is still modest in comparison with the size of the public sector debt.

Some fiscal tightening, coupled with what we view as a "behind the curve" BOJ that continues to exert some financial repression by raising rates but keeping them below nominal growth levels, could be just what Japan needs to maintain 2% inflation while bringing down the real value of public sector debt. We estimate inflation in Japan is likely to trend between 1% and 2% – still below the BOJ's formal target, giving the central bank room to continue to run accommodative policies.

Through a mix of modestly tighter fiscal policy and higher nominal growth relative to real rates, Japan's path forward has potential to be smooth, creating enticing investment opportunities and fostering higher rates of savings for aging Japanese households. Japan's policymakers are well aware that a fiscal adjustment that is too aggressive could send the economy back to where it languished too long: in a flat to mildly deflationary steady state.

For more on Japan's monetary policy, read our recent piece, "Bank of Japan's Policy Shift Ushers in a New Era for Investors."

Read the previous edition of Macro Signposts on how the U.S. Federal Reserve may be returning to an "opportunistic disinflation" approach to monetary policy.

We welcome your questions about the global macro landscape. Don't hesitate to suggest themes or data for us to analyze and discuss: Please email [email protected].

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