A "Japan taper" is one of those outsized risks that investors would rather not take seriously - unless they absolutely have to. The Bank of Japan has informally begun debating an exit from record stimulus, Reuters reported this week. Yet, the bond market is unperturbed: the yield on 10-year Japanese government bonds (JGBs) remains a measly 0.57 per cent.
This calm prevails because markets believe the BOJ is unlikely to repeat its mistake of 2006. Back then, it put an end to quantitative easing and raised interest rates. The hawkishness choked off a fragile recovery. Instead of investing in new factories and machines, Japanese companies went back to squirreling away earnings in financial assets. The government had to borrow and spend to keep nominal GDP from shrinking too much, especially after the 2008 crisis. Japan's public finances stopped improving.
A similar move now would be equally disastrous. A premature end to ¥50 trillion ($490 billion) in annual stimulus would sour investor sentiment. Inflation expectations, which have firmed since BOJ Governor Haruhiko Kuroda launched his asset-buying programme last April, would go limp. The real cost of capital would increase. Investment demand would wane and wages would fall, undermining Japan's plans for a second increase in the consumption tax. That, in turn, would thwart efforts to fix the country's rickety public finances.
The argument in favour of an early taper is that money-printing can't continue at this pace. The BOJ's JGB portfolio has already swelled to 31 per cent of Japan's GDP. By comparison, the US Federal Reserve's holdings of Treasury bonds are just 14 per cent of American GDP. And while the Fed is winding down its purchases, the Japanese central bank is still buying.
But the BOJ also has the harder task of rescuing an ageing society from 15 years of deflation. It can't get off the treadmill so soon. The more overconfident policymakers get about hitting their two per cent inflation goal in 2016, the more attention investors will pay to the taper rumours.
Higher bond yields and a stronger yen would threaten Japan's revival, forcing the monetary authority to reverse course and print money even more furiously. Stoking such perverse self-fulfilling expectations will be nothing short of a spectacular self goal.
This calm prevails because markets believe the BOJ is unlikely to repeat its mistake of 2006. Back then, it put an end to quantitative easing and raised interest rates. The hawkishness choked off a fragile recovery. Instead of investing in new factories and machines, Japanese companies went back to squirreling away earnings in financial assets. The government had to borrow and spend to keep nominal GDP from shrinking too much, especially after the 2008 crisis. Japan's public finances stopped improving.
A similar move now would be equally disastrous. A premature end to ¥50 trillion ($490 billion) in annual stimulus would sour investor sentiment. Inflation expectations, which have firmed since BOJ Governor Haruhiko Kuroda launched his asset-buying programme last April, would go limp. The real cost of capital would increase. Investment demand would wane and wages would fall, undermining Japan's plans for a second increase in the consumption tax. That, in turn, would thwart efforts to fix the country's rickety public finances.
More From This Section
But the BOJ also has the harder task of rescuing an ageing society from 15 years of deflation. It can't get off the treadmill so soon. The more overconfident policymakers get about hitting their two per cent inflation goal in 2016, the more attention investors will pay to the taper rumours.
Higher bond yields and a stronger yen would threaten Japan's revival, forcing the monetary authority to reverse course and print money even more furiously. Stoking such perverse self-fulfilling expectations will be nothing short of a spectacular self goal.