In a prior blog post
, I outlined some important guidance Bank of Japan (BOJ) deputy governor Kikuo Iwata outlined in a speech on October 18. We continue that discussion here with a look at how Iwata sees the BOJ’s activities manifesting in changing inflation expectations and portfolio allocations of Japanese households.
Let’s start with why Iwata believes the BOJ’s monetary easing program known as quantitative and qualitative monetary easing (QQE)
lifts inflation expectations:
The reason behind the lift in inflation expectations owes much to the market expectations that a sharp increase in the monetary base … will eventually lead to an increase in bank lending, and hence an increase in the amount of money (i.e., sum of cash and deposits) circulating in the economy. If the money in the economy increases, people will expect that it will be used partly for the purpose of purchasing goods and services, and eventually the rate of inflation will start to pick up as well.1
Iwata showed a graph of nominal interest rates
, expected real interest rates
on inflation-adjusted bonds
, and then the break-even inflation rate
that is implied from the difference between the two interest rate series. One can see expected real rates have been on the decline. Although to be fair to prime minister Shinzo Abe, the decline in real rates started with Abe’s election in November, when the break-even inflation rate was close to 0.50%—it has since risen well above 1%. The expected real interest rate in September is really not much lower than when the BOJ began its QQE program in April.
Interest Rates and Inflation Expectations (1/1/2012–9/30/2013)
But there is increasing evidence that inflation expectations are becoming more firmly established. Beyond the break-even inflation rates, survey data confirms households are expecting inflation. Iwata stated that 83% of respondents to a Bank of Japan survey expected prices to go up one year from now.2
Iwata further stated that the rise in inflation expectations should manifest in shifting portfolio allocations from cash, which earns 0% interest rate and potentially suffers from declines in purchasing power
, toward foreign assets and equities. And the portfolio flow data is starting to bear out this shift in allocations. Iwata illustrated the occurring shifts:
According to recent statistics, the financial assets of households at end-June 2013 increased by 5% on a year-on-year basis. Looking at this in detail, while bonds decreased by 9%, shares and equities increased by 31% and investment trusts rose by 29%. The portfolio rebalancing … is actually taking place.3
Japanese Household Assets (as of 6/30/2013)
The increase in both equities (at approximately 30%) and investment trusts (such as mutual funds) is impressive but still needs to be put in the context of the low bases they were starting from. Only 8.1% of Japan’s household assets were in shares and other equities, and only 4.5% of total assets were in investment trusts. A full 54.1% was still in “currency and deposits”—or being left in the bank and under the proverbial mattress. These assets are earning essentially a 0% rate of return and suffering losses in purchasing power.
The types of increases in equities and investment trusts we saw in the first and second quarters of 2013 are an important start, but they are just that—a start of what could be a critical adjustment in portfolio allocations. As we discussed in our last blog post
, the BOJ’s QQE program is meant to reduce the risk premium
(i.e., support higher prices) for the equity markets through their purchases of equities. This recent evidence of households shifting portfolios is thus an encouraging ramification of the QQE program, but I believe we are only in the very early innings of a large shift in portfolio allocations. This shift, if it continues, will be a big driver of Japan’s equity markets over the years and is one of the reasons why I am optimistic for the prospects on Japan’s markets.
Kikuo Iwata, “Purpose and Mechanism of Quantitative and Qualitative Monetary Easing,” Bank of Japan, October 18, 2013.