Exit from the Abenomics Policy Framework Will Likely Strengthen Appreciative Pressure on the JPY

A significant correlation exists between the yield and net domestic fund demand differential and the USD/JPY exchange rate. When the yield differential or the gap in net domestic fund demand between Japan and the US widens, it exerts increased downward pressure on the JPY's value. Nonetheless, a notable alteration in this relationship has been observed since the onset of Abenomics, marked by a structural transformation in the JPY's response.If the government shifts away from the Abenomics policy framework, the inherent downward pressure on the JPY's value is likely to dissipate, potentially leading to a rapid appreciation of the JPY. Such a scenario would likely prompt businesses to reduce prices due to the stronger JPY, consequently intensifying deflationary tendencies.Conversely, if the government and the Bank of Japan persist with the Abenomics policy framework, their intent likely revolves around reshaping the established norms regarding Japan's wage and inflation dynamics. This endeavour seeks to extricate Japan entirely from the grip of deflation.The 2-year yield spread between the United States and Japan has undergone a substantial increase, rising from 0.25% in the first quarter of 2021 to reach 4.73%. This enlarged disparity in yields has exerted pressure that weakens the value of the JPY. Beyond the variance in yields, the intensity of monetary demand (or the capacity for money to expand) within the economy has likely fortified the downward pressure on the JPY's strength. The quantum of monetary demand in the economy is contingent on the savings behaviours of corporations and the government, which are the primary net borrowers in the economic landscape. By aggregating the corporate savings rate and fiscal balance, one can infer the potential for money to expand within a given economy. A heightened capability for money expansion is likely to contribute to the diminishing strength of the currency.

During the initial stages of the pandemic, fiscal expenditure experienced significant growth in key economies. In the US, net domestic fund demand surged to approximately -16% at its peak. Nevertheless, as economies began to normalize and transition to a post-Covid era, fiscal spending tapered, leading to a reduction in net domestic fund demand to around the long-term average of -5%. Meanwhile, Japan's net domestic fund demand did not experience as much expansion but remained stable at approximately -3%, even as the country moved into a post-Covid phase. Consequently, the difference in net domestic fund demand between the US and Japan narrowed from approximately -10% in the third quarter of 2021 to around -3% by 2022. The relative decrease in the potential for money expansion in the US compared to Japan likely added to the weakening pressure on the JPY.

A robust correlation exists between the yield differential and net domestic fund demand disparity, and the USD/JPY exchange rate. As the yield differential or net domestic fund demand gap between Japan and the US expands, the depreciation pressure on the JPY intensifies. However, since the commencement of Abenomics, a structural shift of JPY10 seems to have taken place within this relationship. The continuous adherence to the Abenomics policy framework by the government and the central bank appears to be exerting a persistent structural downward pressure on the JPY, regardless of variations in yields or net domestic fund demand. This pressure, in turn, appears to be functioning as a supportive factor for Japan's economic growth and price levels.

If the government deviates from the Abenomics policy framework, the structural downward pressure on the JPY is likely to subside, potentially leading to a sudden appreciation of the currency. Under such circumstances, businesses are likely to reduce prices in response to the stronger JPY, subsequently amplifying deflationary pressures. Thus, by persisting with the Abenomics policy framework, the government and the Bank of Japan are likely aiming to redefine the established norms regarding wage and inflation dynamics in Japan, with the goal of completely overcoming deflation.

The government reiterated its commitment to the Abenomics framework in the most recent Basic Policy on Economic and Fiscal Management, underscoring its dedication to maintaining Abenomics to eradicate deflationary mindsets and ensure the economy remains free from deflation. The government's definition of "not returning to deflation" appears to entail a complete departure from deflation.

At the BoJ's monetary policy meeting, the Ministry of Finance has consistently communicated that the government expects the Bank to conduct appropriate and sustainable monetary policy to achieve the target of price stability, while closely collaborating with the government. Likewise, the Cabinet Office, which also participates in BoJ monetary policy meetings, maintains its stance that the Bank should continue with monetary easing in a patient manner, striving for a sustainable and stable achievement of the 2 percent price stability target, coupled with wage increases, while considering economic and price developments, along with financial conditions.

Meanwhile, Governor Kazuo Ueda maintains his position that the risk of inflation falling short of 2% due to premature tightening is greater than the risk of inflation overshooting 2% from the Bank not tightening, and he believes that waiting for underlying inflation pressures to strengthen does not entail significant costs.

USD/JPY and Japan-US interest rate difference

 Source: BoJ, Cabinet Office, Bloomberg, Credit Agricole CIB

USD/JPY and Japan-US net domestic fund demand difference

 Source: BoJ, Cabinet Office, Bloomberg, Credit Agricole CIB

Japan economics forecast table

 Source: Crédit Agricole CIB

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