July 31, 2015

The IMF, after playing a major role in the complete collapse of Greek activity and the exploding Greek debt burden with its insistence that fiscal austerity solves every problem from Ghana to Greece, has now turned its attention back to Japan.

“The Bank of Japan needs to stand ready to ease further, provide stronger guidance to markets through enhanced communication, and put greater emphasis on achieving the 2 percent inflation target in a stable manner”  – IMF 2015 Article IV consultation with Japan

The failure of “Abenomics” to deliver a steady and sustained 2% plus inflation rate can easily be explained by the chart below. It shows the Output Gap i.e. the gap between actual output and potential output in the economy and the inflation rate. The recent spike in inflation was a one-off impact from tax increases that is fading away. Inflation has now slipped back to where it should be.


Japanese inflation is highly correlated with the economic cycle; when activity accelerates and the Output Gap closes we see inflation follow (and vice versa).

So, what is needed to get inflation sustainably higher in Japan is sustainably higher economic growth that removes the Output Gap and turns it positive i.e. gets the economy running above its potential.

The answer from the IMF/Bank of Japan to that challenge? Quantitative Easing (QE), of course… lots of it.

  • The Bank of Japan now owns 22% of outstanding Japanese government debt versus just 7% two years ago.
  • The Bank of Japan’s balance sheet is now 60% of GDP, almost double the size two years ago.

The chart below shows the growth in Bank of Japan Assets (QE purchases of assets) dwarfing the net issuance of equity in the Non-Financial Corporates sector and net issuance of government debt. An increase in QE and Bank of Japan asset purchases would give a further significant boost to asset price inflation (stay long Japanese equities), but we very much doubt it will boost activity and shrink their Output Gap.



Well, take a look at the assets of Households and Liabilities of the corporate sector:

  1. Japanese Households hold very little of their assets in equities and bonds and so the economy gets very little benefit from any wealth effect arising from an increase in the value of these securities. They own lots and lots of cash primarily.


  1. Japanese Non-Financial Corporates have less than half their financial liabilities in equity, with almost 30% in loans and bonds where yields are near the zero level already.



  • Expect the Bank of Japan to expand QE further (from 80 trillion yen, 16% of GDP a year at present) – keep pushing that string until it budges…
  • More QE = more local asset inflation = weaker Yen (until such time as the US market heads south, at least).