Analysis: New BOJ chief faces credibility test after landing top job

Japanese lawmakers paved the way on Friday for a new central bank governor whose plan to defeat deflation rests on the belief that pumping huge amounts of yen into the economy will convince the public to start spending now because prices will rise.

Critics say policies advocated by Haruhiko Kuroda, endorsed by parliament to lead the Bank of Japan, are a leap of faith. The BOJ has been pumping cash into the economy for years without ending nearly two decades of grinding deflation.

How will doing more of the same make a difference, their argument goes.

"There's no clear explanation from Kuroda yet on how and to what degree expanding the BOJ's balance sheet further could push up prices," said Hideo Kumano, a former central banker and now chief economist at Dai-ichi Life Research Institute.

Nearly two decades of low-grade deflation have entrenched the view in a generation of Japanese that prices steadily fall. By some measures the Bank of Japan is already the most aggressive in the industrialized world.

The main argument of Kuroda and Kikuo Iwata, confirmed on Friday as deputy governor, is that the central bank should change that mindset by being much more aggressive in expanding its balance sheet. In that way it will be able to reach a 2 percent inflation target in two years.

Indeed Iwata, suggests the target can be reached once excess bank reserves parked with the central bank reach 80 trillion yen.

BOJ forecasts suggest those reserves will surpass that amount this year, but that a key measure of consumer inflation will not even reach 1 percent, casting doubt on the new leaders' argument that once the BOJ starts ramping up the printing press, its 2 percent inflation target will be in sight.

"Suppose you go to a doctor and he prescribes two doses of a medicine a day and it doesn't work. So he says four doses a day, and it still doesn't work. So you go to eight, sixteen, 256. Aren't you supposed to suspect that this doctor is treating a disease that you don't have?" said Richard Koo, chief economist of Nomura Research Institute in Tokyo.

Koo says monetary easing can play a role when combined with fiscal stimulus and economic reforms, but has long argued its effectiveness has been well overestimated when interest rates are at zero and households and companies are not borrowing.


In parliamentary hearings, Kuroda argued that by showing its resolve to beat deflation, the BOJ can keep a lid on the yen. That would increase manufacturers' earnings and encourage them to spend more on investment and wages.

Iwata believes that same resolve will nurture inflation expectations.

"Monetary policy is effective in changing deflationary expectations into inflationary expectations," Iwata told a confirmation hearing at the upper house this week.

The BOJ is already creating huge amounts of cash and expects its monetary stimulus to boost the cash and reserves held by banks to 170 trillion yen by December, up 29 percent from a year earlier.

That represents roughly 36 percent of Japan's nominal GDP, compared with 17 percent for the U.S. Federal Reserve and 16 percent for the European Central Bank, according to BOJ estimates.

The value of current account deposits placed by banks with the BOJ - a measure of spare cash in the economy - is set to almost double by the end of the year to 85 trillion yen from 44 trillion yen now.

That is also more than double the peak level during the BOJ's five-year quantitative easing policy of 2001-2006 and tops the roughly 80 trillion yen Iwata has said was needed to generate inflation expectations of 2 percent.

Still, the BOJ expects core consumer prices, which exclude volatile fresh food prices, to rise 0.4 percent in the year to March 2014, higher than a 0.3 percent median forecast in a Reuters poll of analysts, and 0.9 percent in the following year.

Another challenge in trying to influence psychology is a lack of credible means to gauge inflation expectations.

Prolonged deflation has meant investors had little incentive to hedge against inflation, so the market for inflation-linked bonds in Japan is small and not a reliable indicator.

BOJ officials say the central bank's current approach of trying to further reduce already ultra-low borrowing costs down is nearing its limit. But they also say there is no evidence that buying longer-dated bonds as Kuroda and Iwata suggest will work either.

"There's no proven co-relation," said an official familiar with the central bank's thinking. "But if people say you never know unless you try, that's also true."


Analysts say Japan's deflation will not be defeated unless wages also rise to give Japanese more confidence to spend. Average earnings have fallen faster than core consumer prices in the past decade or so as companies have traditionally offered bonuses rather than wage increases. Toyota Motor Corp <7203.T> did just that this week.

Combined with the fact that about a third of Japan's workforce is shut out from any benefits because it is made of temporary or contract workers, it may take a long time before wages rise, assuming company earnings improve as the weak yen bolsters export-led industries, analysts say.

For now, the drop in the yen to a three-year low close to 97 per dollar is the most visible benefit of Kuroda's prescription as financial markets anticipate that the BOJ will keep churning out freshly minted yen.

But the effects of a weaker yen on exports will at some point wear off and once overseas sales plateau, Japanese companies must face the reality of toughening competition abroad and a shrinking and ageing population at home, analysts say.

"Expectations of further easing are already priced into the market so the dollar won't exceed 100 yen. It will be stuck in a range around 95 yen," said Eisuke Sakakibara, a former government official known as "Mr Yen" because he oversaw aggressive currency intervention. He is now a professor at Tokyo's Aoyama Gakuin University.

"It's extremely difficult to achieve (2 percent inflation in two years) just with monetary policy."

(Additional reporting by Tomasz Janowski and Yoshifumi Takemoto)