1. Paul M. Kitney, PhD
BALLINGAL INVESTMENT ADVISORS
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The Animal Spirits Report - Asia Pacific Investment Strategy
September 19, 2016
ANIMAL SPIRITS™ REPORT:
BOJ “Comprehensive Assessment”:
Tokyo Visit Takeaways
Executive Summary
• NIRP is believed to have worked and in all probability will not be reversed at
the September 21 BOJ meeting.
• QQE will not likely taper overall.
• But a "twist" will probably be attempted to steepen the yield curve to nullify
the ill effects of NIRP on bank margins and insurance companies' embedded
value.
• There is a good chance corporate bonds will make the QQE buy list.
• Foreign bond purchases are a low probability event.
• Fiscal Monetization (Helicopter Money) is not possible yet.
Background
(TOKYO) Animal Spirits spent the past week in Tokyo, meeting with our market,
academic, and think-tank related policy network. Many clues to what is likely to
transpire in this week's (September 21) BOJ meeting are contained in the
September 5 Kuroda speech on the "Comprehensive Assessment" of the
Monetary Easing: Concepts and Approaches. This assessment will be a review of
the effectiveness of monetary policy in relation to stated goals and provides a
framework for understanding the benchmarks used to evaluate both legacy
policies - Qualitative and Quantitative Easing (QQE) and the Negative Interest
Rate Policy (NIRP) - and possible alternatives to the current policy regime.
This note should be read in conjunction with:
ANIMAL SPIRITS™ REPORT: Fiscal-Monetary Policy Interaction: A Primer
Upcoming Animal Spirits Report:
ANIMAL SPIRITS™ REPORT: Japan Equity Market Outlook – Springing The
Value Trap
is owned by Paul M. Kitney, PhD, licensed to Ballingal Investment Advisors
and is pending registration.
ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS
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PAUL M. KITNEY, PhD
The BOJ targets real interest rates and is failing due to credibility and
coordination issues
Real interest rates are defined as nominal interest rates minus inflation
expectations. QQE and NIRP have successfully reduced the full range of nominal
interest rates but have not raised inflation expectations sufficiently to guide real
rates to a level low enough to boost consumption and investment demand to
the point where inflation is self-sustaining. The BOJ concedes that the 2 percent
inflation target is not "credible". This means agents (households and firms) are
not setting inflation expectations at the BOJ target. Also, the expectations
formation mechanism is not "forward looking" (rational expectations) but rather
expectations are being formed using an "adaptive learning" mechanism. This is
where beliefs update by a learning method that responds to observed data
("adaptive learning" has been popularized by some central bankers, including
Jim Bullard of the St Louis Fed).1
In this case, expectations are not "anchored" at the forward-looking 2 percent
target but rather around zero (ZLB deflation mentality), where realized (not
expected) inflation data points have clustered during Japan's extended period of
stagnation. His intention is clearly to jolt economic dynamics to a path where
agents in the economy (firms, households, the central bank and financial
intermediaries) can coordinate on a single (determinant) equilibrium, where
agents using their adaptive expectations mechanism can "learn" the inflation
target (expectational stability or "e-stability"). That is, Kuroda is keen to make
the BOJ inflation target "credible", which the US has been able to achieve.
1For the technically inclined, the author has written an academic paper in this area of determinacy and
learnability in monetary economics: Kitney, P. Financial Factors and Monetary Policy: “Determinacy and
Learnability of Equilibrium”, CAMA Working Paper 41/2016 July 2016, Centre for Applied Macroeconomics,
Australian National University.
ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS
“...the mechanism of inflation expectation formation in Japan is still largely
"adaptive", meaning that, when the observed inflation rate shows sluggishness,
due to such factors as the decline in crude oil prices and the temporary
weakness in demand, inflation expectations tend to decline accordingly...the
forward-looking formation mechanism...will revert to the price stability target
set by the central bank, which is 2 percent in many countries. On the other
hand, the adaptive formation mechanism points to the view that the inflation
rate will continue to be around the current level. For instance, if the observed
inflation rate has been around 0 percent, people believe the inflation rate will
be around 0 percent going forward...in Japan, as the price stability target has
been missed under prolonged deflation, the effects of the adaptive formation
mechanism seem to have dominated (as opposed to the credible Fed and the
forward looking expectations in the US)" (p.4-5, Kuroda Speech, September 5).

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PAUL M. KITNEY, PhD
The headwinds that have held back inflation expectations should reverse later
in 2016
Given that inflation expectations are anchored near zero in Japan, the
conclusion is QQE has done a decent job but it has not been enough to offset
the influence of external factors such as oil prices, rising external risk premium
(and credit spreads). However, the external environment may well be changing
in the coming months. In the September 1 note, ANIMAL SPIRITS REPORT 1:
Macro Backdrop - Base Jumping the Fed with Oil and Inflation Expectations we
demonstrate the role of oil prices in inflation expectation formation and make
the case that inflation expectations are likely to rebound favorably from late this
year, especially between November 2016 and May 2017, due to the oil base
effect and evidence from the EIA and IEA that the demand-supply in liquid fuels
is rebalancing. The BOJ is surely aware of this and given the labor market is
tightening (27 year high in job offers to applicants) there is a good likelihood
that the spring wage negotiations (Shunto) will be positive in this environment
during Q2 2017.
Kuroda repeats several times in his speech the need to achieve the inflation
target to re-establish policy credibility and to get the economy onto a "forward-
looking" path, which gives the central bank more control over macroeconomic
stabilization policy. We are impressed by the implicit determination in this
language so expect a committed attempt to use the momentum of the
upcoming "deflation hiatus" to try and break the shackles of the the "deflation
mentality" and re-establish credibility of the BOJ's inflation target.
Possible Changes to the Policy Mix Following the "Comprehensive
Assessment"
1. QQE will not likely taper in aggregate
As explained in the previous section, the BOJ is determined to re-establish
inflation targeting credibility and QQE is a stated vehicle for the achievement of
this goal.
2. NIRP is believed to have worked and in all probability will not be
reversed near term
ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS
“A reduction in the level of monetary policy accommodation, which is called for
by some market participants, will not be considered” (p.2, Kuroda Speech,
September 5)
“It has become clear that the Bank can affect the entire yield curve through an
appropriate combination of the negative interest rate policy and JGB purchases.
The framework of QQE with the negative interest rate has proven to be
extremely powerful. (p.6, Kuroda Speech, September 5)

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PAUL M. KITNEY, PhD
3. A "twist" in the QQE may be attempted to increase the yield curve slope
Kuroda recognizes that the flatter and on occasions negative yield curve
following the establishment of NIRP in January this year has hurt bank and
insurance company profitability, via lower NIMs and depressed embedded
values, respectively (p. 6-7, Kuroda Speech, September 5) . In our opinion, this
was not anticipated by the BOJ and given the macro-prudential role of the
central bank, the introduction of policies that undermine the profitability and (in
the long run) the solvency of financial intermediaries, runs counter to the
central bank charter. Consequently, Animal Spirits believes the BOJ will consider
measures to steepen the yield curve such as concentrating buying at the short
end and slightly taper at the long end of the term structure to achieve this.
4. Domestic corporate bonds are a good chance but foreign bonds have a slim
chance to be added to QQE
In addition to the language on margins in the financial sector, Kuroda lists
corporate profit margins first in the list of positive outcomes from QQE.
Improving corporate profitability is an inflationary policy of the BOJ. The
improvement in margins since 2012 has come mostly from the weakness in the
JPY (via the J-curve effect on the export-led manufacturing sector), in large part
from QQE. In recent times, the ability of QQE to effect a weak JPY outcome has
diminished. Conceivably, the BOJ could consider foreign bond purchases to
achieve a similar end. However, we think this will be avoided for now due to
political sensitivities precluding FX intervention. Yet, we believe that following
the ECB and buying corporate debt would improve non-operating income,
lowering cost of capital for firms, especially SME's, which would have a positive
impact on profit margins, as they are apparently part of the BOJ plan.
5. It is not the time for fiscal monetization (Helicopter Money) yet
In ANIMAL SPIRITS™ REPORT: Fiscal-Monetary Policy Interaction Explained, we
highlight the benefits of fiscal monetization, including the superior fiscal
multiplier that should be associated with this policy mix. However, for now,
Kuroda has made it clear it is not within the legal framework of the BOJ.
However, during a reformist administration that is looking at the
reinterpretation or revision of Article 9 of the Japanese constitution, then a
modification to the charter of the BOJ to allow fiscal monetization, is possible in
the future if it is deemed necessary, in our opinion.
ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS
“...since the introduction of QQE...corporate profits, measured by the ratio of
current profits to sales, marked a record high level in fiscal 2015” (p.2. Kuroda
Speech, September 5)
“...there is a limit in the sense that there are things that "cannot be done
legally" or "should not be done" such as directly underwriting government
bonds and monetizing fiscal deficits...” (p.9. Kuroda Speech, September 5)

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PAUL M. KITNEY, PhD
ANIMAL SPIRITS • BALLINGAL INVESTMENT ADVISORS