BOJ juggles yen weakness and fragile growth after GDP surprise

BOJ juggles yen weakness and fragile growth after GDP surprise

An editorial image of a falling graph in front of the Japanese flag.

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Japan's central bank is expected to exit its negative interest rate regime this spring, although sluggish growth will limit its ability to ease devaluation pressure on the yen, according to a former Bank of Japan board member.

BOJ Governor Kazuo Ueda is under pressure to curb the yen's depreciation caused by the divergence between high U.S. interest rates and Japan's ultra-loose policies. However, it is also constrained by high inflation, which BOJ policymakers still consider unsustainable even as it curbed domestic demand and plunged the economy into a technical recession. This surprising decline resulted in Japan's economy now being the fourth largest in the world, falling behind Germany.

“It's a serious challenge and dilemma,” Sayuri Shirai, an economics professor at Keio University in Tokyo, told CNBC's “Squawk Box Asia” on Thursday. She previously served on the BOJ's policy board from 2011 to 2016, helping with monetary policy decisions.

“However, I think the BOJ is likely to make some policy changes, including [the] “I will be pushing for the abolition of negative interest rates this spring because I think they are worried about side effects,” she said.

The yen fell to around 150 per dollar this week after higher-than-expected U.S. inflation data, dashing hopes of a quicker rate cut by the Federal Reserve. The yen's chronic weakness has not only reduced the purchasing power of consumers in Japan, but also the value of the country's exports.

“I think they want to take this opportunity to make some adjustments and also more market participants are anticipating that the BOJ will do some normalization this spring. Regardless of whether the BOJ is able to reach 2% in a stable manner, I think the BOJ will make some adjustments.” “There will be a policy change this spring,” Shirai added.

Although BOJ policymakers believe inflation is still not sustainably driven by domestic demand, persistently high inflation rates have weighed on domestic consumption – a key reason for Japan's second consecutive decline in GDP in the fourth quarter.

While inflation is gradually slowing, “core inflation” – which excludes food and energy prices – has been above the BOJ's 2 percent target for more than a year.

At its January meeting, the BOJ unanimously decided to keep short-term interest rates at -0.1%. It also stuck to its yield curve control policy, which keeps the cap on the benchmark 10-year Japanese government bond yield at 1%.

BOJ policymakers have been cautious and diligent in their primary task: revitalizing an economy mired in deflationary pressures for decades.

Many in the market expect the BOJ to move away from its negative interest rate regime at its April policy meeting once annual wage negotiations in the spring confirm a trend toward significant wage increases. The central bank believes that wage increases would lead to a more sensible spiral and encourage consumers to buy.

However, Shirai, a former BOJ Council member, said that both Japanese yen-denominated wages and household consumption are currently falling.

“And so there is no evidence that your cycle between price and wages looks like that [consumer] Demand. In this sense, it is quite difficult for BOJ to endure [the path of] Normalization, although inflation may be above 2% for some time,” she added.

“But at the same time there is this interest [rate] Difference leads to enormous reduction in value [pressure for the Japanese yen] … So you see it is very difficult to raise interest rates,” Shirai said.

“Even if the Bank of Japan raises interest rates a little, the BOJ has to say that it cannot raise rates continuously because the economy is weak. If they do some normalization, [it would be] Only [the] Abolition of negative interest rates – then that doesn’t really have a big impact on the devaluation of the yen.”

—CNBC's Lee Ying Shan contributed to this story.