TOKYO, June 13 (Reuters Breakingviews) - Bank of Japan Governor Kazuo Ueda knows well the risk of tightening policy prematurely. Attempts to slow stimulus and raise borrowing costs by his predecessors have backfired repeatedly since 1997. Investors worry about market ructions if Ueda hikes rates now but there is another risk: that he waits too long.

Since taking the helm from Haruhiko Kuroda in April, Ueda has enjoyed a quiet market honeymoon. The yield on the benchmark 10-year bond has stopped testing 0.5%, the high end of its trading band set by the BOJ, and the Nikkei 225 large-cap equity index, up 20% in the last three months per Refinitiv data, is the world’s best performing major benchmark, slightly ahead of the Nasdaq Composite.

That is because Ueda’s decision to keep ultra-low interest rates in place for now has eased investors’ worries that rising inflation and a collapsing yen would force him to start tightening monetary policy right out of the gate. That could have prompted an accelerated repatriation of funds Japanese investors have parked abroad in search of better returns – a process that is already getting underway as currency hedging costs rise. Bank for International Settlements data shows Japanese entities held over $5 trillion in overseas assets at the end of 2022, higher than any other country.

Ueda’s inaction – and the domestic markets’ positive response – have bought him time to focus on evaluating macroeconomic fundamentals, particularly inflation. Here is where his job gets complicated.

The country only emerged from a decades-long deflationary rut relatively recently, so local economists, executives and consumers are unused to worrying about consumer prices rising too fast. That might help explain why many policymakers and economists dismiss the recent spike as temporary, driven by imported factors. Yet that may be changing. The economy has exited recession, and the “core-core” Consumer Price Index, which excludes volatile food and energy items, rose at an annualised rate of 4.1% in April, well above the BOJ’s 2% target. In addition, the general services component, which excludes government services and is largely insulated from external factors, is now growing at an annual rate of 2% a year, a 28-year high. The unemployment rate is falling and private consumption is rising, as is demand for credit.

If workers demand and get higher wages to compensate for the jump in their living costs, Japan could face a long-term rise in inflation that would need a gradual monetary tightening. Unfortunately for Ueda, the picture is muddy. Annual wage hikes negotiated by the country’s largest unions in April averaged around 3%: high by historical standards but below CPI - albeit with some dramatic exceptions like Fast Retailing (9983.T), owner of the Uniqlo clothing chain. And an intense worker shortage in some sectors is pushing up non-union and informal pay.

TIMING THE MARKET

It is worth remembering that Japan was once one of the world’s frothiest economies. Ripping export-driven growth led by manufacturing champions like Toyota Motor (7203.T) and Toshiba (6502.T) helped fuel exuberant speculation in domestic real estate and shares between 1986 and 1991.

The BOJ recognised the problem as early as 1987 but officials were rattled by the Black Monday stock market crash in the United States. They waited two years to act. When the central bank officials began belatedly raising rates, they set off a collapse in land prices comparable to the U.S. Great Depression in the 1930s. Economist Richard Koo estimated falling values erased 1,500 trillion yen ($9 trillion in 1990 dollars) of national wealth, the equivalent of three years of GDP.

Japan is nowhere near to the frothy conditions of the 1980s, when the economy expanded at rates ranging between 3% and 7% per quarter. Output grew only 1.6% on an annualised basis in the three months ending March and external demand for Japanese exports is weak. Japan Inc still sits on vast uninvested reserves.

The threat of a demand-driven inflationary spiral still seems far-fetched in a slow-growing, fast-aging nation where cash-hoarding has been reflexive. Since Japan’s bubble popped, attempts to pull back on fiscal spending, hike consumption taxes or lift borrowing costs have proven ill-advised. Hiking benchmark interest rates in 2000 was disastrous – long term lending rates actually fell in response, and the decision had to be reversed. Ditto for a more recent experiment by then-Prime Minister Shinzo Abe with raising the consumption tax. The government’s latest draft of its long-term economic plan, seen by Reuters on June 2, remains focused on eradicating Japan's “long-held deflationary mindset”.

But the global economic context has now changed completely, and long-running trends like supply chain diversification out of China look to keep sustained upward pressure on costs. In that context, a combination of rising prices and tepid growth would be especially hard on a society like Japan, where so many pensioners live on fixed incomes.

The risks are clear. In 2021 and 2022, central bankers in the United States and Europe disregarded signs prices were getting out of hand until very late in the game, with less excuse than the Japanese. The resulting steep rise in interest rates - since March 2022 the Fed has yanked its target to a range of 5% to 5.25% from 0.25% to 0.5% - whipsawed securities markets and caused bank failures in the United States. Germany and Italy, both of which have similarities to Japan, are still struggling to revive their economies.

There is little evidence that prices are overheating yet. But if they do, recent history shows time is off the essence. If policymakers dither, they might end up having to dramatically tighten policy in a belated panic as Western central banks did. That would knock down bond prices and set off a sharp yen rally - the currency has lost over a quarter of its value against the dollar since 2021. A jump in the yen would damage Japan’s exports and depress the local-currency value of overseas sales at major exporters like Toyota, hurting profitability. Economic growth, which the International Monetary Fund expects to be a meagre 1.3% in 2023, would probably contract and trillions of Japanese dollars would come back home from overseas equities, fixed income, mutual funds and private equity. That could deliver an even harsher global shock than premature normalisation.

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CONTEXT NEWS

Japan's wholesale inflation slowed for a fifth consecutive month in May because of sliding fuel and commodity prices, official data showed on June 12. The corporate goods price index, which measures the price companies charge each other for goods and services, rose 5.1% in May compared with a year earlier, slower than the median market forecast for a 5.5% gain.

Bank of Japan Governor Kazuo Ueda said on May 30 that the central bank would patiently maintain its ultra-loose monetary policy because he believed current high inflation levels would not be sustained. "We expect inflation to quite clearly slow below 2%" toward the middle of the current fiscal year, Ueda told parliament.

Consumer prices excluding volatile food and energy items rose 4.1% in April, outpacing the core measure by 70 basis points.

The Bank of Japan’s next policy meeting will end on June 16.

Editing by Francesco Guerrera and Katrina Hamlin

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