Paul M. Kitney, PhDBALLINGAL INVESTMENT ADVISORSpaul@ballingal.com+852 2733 1000 (Main)+852 2733 1031 (Direct)+852 6975 8444 (Mobile)

The Animal Spirits Report - Asia Pacific Investment StrategySeptember 19, 2016

ANIMAL SPIRITS™ REPORT: BOJ “Comprehensive Assessment”:Tokyo Visit TakeawaysExecutive 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 PrimerUpcoming 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.

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The BOJ targets real interest rates and is failing due to credibility and coordination issuesReal 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 andlearnability in monetary economics: Kitney, P. Financial Factors and Monetary Policy: “Determinacy andLearnability of Equilibrium”, CAMA Working Paper 41/2016 July 2016, Centre for Applied Macroeconomics,Australian National University.

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“...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 temporaryweakness in demand, inflation expectations tend to decline accordingly...theforward-looking formation mechanism...will revert to the price stability targetset by the central bank, which is 2 percent in many countries. On the otherhand, the adaptive formation mechanism points to the view that the inflationrate will continue to be around the current level. For instance, if the observedinflation rate has been around 0 percent, people believe the inflation rate willbe around 0 percent going forward...in Japan, as the price stability target hasbeen missed under prolonged deflation, the effects of the adaptive formationmechanism seem to have dominated (as opposed to the credible Fed and theforward looking expectations in the US)" (p.4-5, Kuroda Speech, September 5).

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The headwinds that have held back inflation expectations should reverse later in 2016Given 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 aggregateAs 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

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“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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3. A "twist" in the QQE may be attempted to increase the yield curve slopeKuroda 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 QQEIn 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) yetIn ANIMAL SPIRITS™ REPORT: Fiscal-Monetary Policy Interaction Explained, wehighlight the benefits of fiscal monetization, including the superior fiscalmultiplier 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 thereinterpretation or revision of Article 9 of the Japanese constitution, then amodification to the charter of the BOJ to allow fiscal monetization, is possible inthe future if it is deemed necessary, in our opinion.

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“...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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