Many people I spoke with in Japan would not be surprised to see the yen reach 110–120 against the U.S. dollar over the course of the next two years. This is a level for the yen I have often discussed as a potential target, given it was trading at these levels back in 2007, before the financial crisis really began, and I have already seen the U.S. financial markets return to their pre-crisis levels.
The BOJ would likely be uncomfortable with a short-term spike to 120. But a gradual depreciation of the yen to that level should be less of an issue. I believe this gradual depreciation of the yen is the BOJ’s ultimate desired outcome. The higher U.S. interest rates go—essentially meaning that Japan is pursuing a more aggressive monetary policy than the U.S.—the more likely the yen is to depreciate further over time.
2014 Consumption Tax Increase—Hinged upon Strong Growth but Likely
Many commentators are focusing on the expected consumption tax increase scheduled to come into effect in April 2014. This is a key tax policy that Japanese policy makers have discussed to raise revenue and help close the country’s large fiscal spending deficits. This tax issue is a stress test for Abe to see how he can manage the complex dynamics of a policy that can improve Japan’s fiscal position yet also have a negative impact by making goods more expensive and slowing down the progress he’s made on his goal of raising economic growth.
Abe has said the implementation of this tax hike depends on market conditions. One investment strategist I spoke with suggested that each 1% increase on the consumption tax only raises an additional 2 trillion yen (a small percentage of the deficit Japan needs to make up), and he believes there is a strong bias toward postponing the tax increase.
Japan’s second-quarter gross domestic product (GDP) numbers came in at 2.6%, a percentage point less than 3.6% expected. The Bank of Japan leaders have made statements that they believe the consumption tax could be implemented at the same time of achieving their goals of ending deflation. When I left Japan, I felt it was a high probability event for the consumption tax to be implemented as expected in April. But this week’s 2nd quarter GDP report may give support to those who want to delay its implementation. We shall learn more in September and October what Abe has planned.
Market Forces
It is still early days for Abenomics, and the initial readings are just starting to come in on how the new economic policies are starting to impact the bottom lines of corporations and consumers. As we get further into the third arrow of Abenomics—the growth strategies—I think we may well be positively surprised by the agenda items Abe tackles. Abe has been bold thus far, and he cannot back down—especially when it comes to labor market policies and countermeasures to Japan’s declining population trends and declining work force.
Jeremy Schwartz is director of research at WisdomTree Investments (NasdaqGM: WETF). This post was republished with permission from the WisdomTree blog.
1Source: Ben McLannahan, “Japan Posts Highest Inflation Rate since 2008,” FT.com, July 26, 2013.
2Source: Bank of Japan.