The 105 level in USD/JPY could well become the ‘line in the sand’ for the BoJ that may spur the bank back into action. To see that, we take a more detailed look at the longer-term path of USD/JPY and PPP. It suggests that the FX cross has deviated considerably from its long-term fair value in the last 30 years. Importantly, a sustained undershoot of USD/JPY below its PPP value could have significant implications for the outlook for the Japanese economy.
In particular, we note that any sustained appreciation of JPY from current levels could weigh on growth and inflation via two channels
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The first is the direct impact on imported inflation. Kuroda is unlikely to want to tolerate strong JPY and thus risk losing credibility, especially when it comes to boosting inflation expectations.
The second, and potentially more important channel, is the impact on the wage-setting behaviour of Japanese exporters. As shown in Figure 3, the sustained appreciation of JPY beyond the levels implied by PPP in the 1990s coupled with an increase in Japanese wages relative to the US but also the drop in the relative labour productivity in Japan meant that the competitiveness of Japanese exporters was severely eroded.
With the JPY overvaluation persisting, labour costs (wages) had to decline in Japan, hurting domestic demand and paving the way for a protracted period of deflation in Japan (Figure 4). What did not help was the fact that an aging population meant that the active employees had to support a growing number of retirees, adding to the headwinds for domestic demand in Japan. Given that the support for domestic demand (eg, higher wages) remains an integral component of Abenomics, we doubt that Japanese officials will tolerate sustained JPY appreciation beyond its long-term fair value for too long. The fact that Japanese labour productivity continues to lag that of the US considerably further strengthens this argument (Figure 3).
What can the BoJ do?
We expect the BoJ to announce additional QE before long. An FX intervention could also become more likely but only if JPY moves into overvalued territory. There doesn't seem to be much scope for further rate cuts given the risk that domestic banks may pass on the penalty rate to their depositors. The resulting negative wealth effect could be a drag on growth and derail the recovery.