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Financial markets have responded robustly in the wake of Brexit with a surge in easing expectations supporting the Nikkei, which has recovered just shy of 14% from the post-Brexit lows. These calmer conditions might perhaps be a reason that the BOJ could use to remain in “wait and see” mode for now though there are a few reasons which strongly argue for immediate action.

Inflation Remains Low

The BOJ spent much of last year remaining optimistic about inflation and the likelihood of inflation returning to the bank’s 2% target in 2016. However, this has not been the case and at their recent meeting the BOJ in fact revised its inflation outlook lower.  The trend in Japanese inflation remains firmly to the downside with YoY Core CPI having fallen from 0.4% in May last year to -0.4% in May this year.

Alongside the continued decline in inflation readings Japan is also suffering from low inflation expectations amongst Japanese corporates with the BOJ Tankan Inflation Forecasts falling for four consecutive quarters from 1.4% in June 2015 to 0.7% in June 2016 highlighting a significant deterioration in business confidence. Indeed, the household inflation outlook survey conducted by the BOJ show that the average 12-month inflation outlook has fallen to 3.8%, the lowest reading since pre-QQE 2012.

With an increasing number of banks and analysts forecasting a sustained downturn in Oil prices over the second half of this as demand falls far short of Supply, inflation is likely to be put under further pressure, placing further focus on the BOJ to counter deflationary effects of such moves.

Easing Expectations Put Pressure on BOJ

Another important aspect of the argument for the BOJ to ease is simply that of elevated market expectations.

According to the monthly Bloomberg News BOJ Meeting survey, more than 75% of 41 industry analysts are expecting the BOJ to announce further easing measures this week with the headline -0.10% rate expected to be reduced by a further 10bps at a minimum and a further 20bps at the maximum.

Speculation regarding the prospect of BOJ easing has fueled a more than 6% bounce off the lows in USDJPY but if the BOJ fail to capitalise on this momentum and either refrain from easing at this stage, or don’t do a good enough job of its, USDJPY is likely to just as quickly crash back below the 100 level again.Speculation ahead of this meeting included rumours of potential “helicopter money”. However, these rumours were dismissed last week when BOJ Governor Kuroda commented that there was “no need and no possibility for helicopter money”, leading to a sharp move lower in USDJPY.  What remains to be seen is whether this remark was genuine or merely intended to help maintain an element of surprise for the BOJ.

Nevertheless, With easing expectations so very high there is obviously a great deal of risk that the BOJ disappoints and suffers a fate similar to that of the ECB in December 2015 which saw the Euro rip higher after the ECB failed to satisfy a market highly expectant of easing. Even if the BOJ is not able to take the market by surprise, it seems reasonable to expect that the BOJ will look to at least satisfy market expectations and avoid a surge in JPY similar to the reaction seen to the announcement of negative rates.

Political Developments Point To Easing

Finally, recent political developments in Japan have increased both the likelihood and necessity of further easing. The re-election of Japanese PM Abe to the Upper House has refueled Abenomics with the PM announcing shortly after his elections that he was ordering another huge round of stimulus. Just this week Abe made a further announcing, unveiling plans for a Y28trln fiscal stimulus package with details to be released next week.The package is expected to include a low-interest rate loan component though at this stage markets are unsure if this package will include new spending.

To date, fiscal spending has seen a reduction in private investment whilst increasing private savings leading to a crowding out of the private sector. If the BOJ can offer some forward guidance vowing not to reduce its balance sheet in future, then investors would interpret this as taking Japan closer to the stage where consumers’ expectations of current fiscal expenditure leading to future tax increases.

Measures expected at tomorrow’s meeting

Market Consensus: Further reduction of interest rates from -0.1% to -0.2% with an increase in the size of ETF purchases from Y3.3trln to Y7trln.

At this stage, it seems clear that if Japan continues to follow the traditional approach of simply cutting rates and/or increasing QE, it is very unlikely to achieve the desired effect. However, within this policy package, it is preferable to see a bigger-than-expected increase in ETF purchases as USDJPY is displaying a stronger correlation with Japanese equity prices than rate spreads whilst a bigger-than-expected rate cut might have unintended effects by provoking concerns over banking stocks.

Following the BOJ rate cut in January, a sizeable burden was put on domestic banks funded mainly via deposits. With deposit rates roughly flat, the liability costs of these commercial banks have not yet eased enough to compensate for reduced asset revenues from the BOJ’s negative rates policy and lending activities have been scaled back. Hence, a move deeper into negative rates would further squeeze these balance-sheet-constrained banks limiting their profitability and weakening their profile.

However, if Japan is able to move away from a traditional approach with both its fiscal and monetary measures then a combination of could work to weaken the Yen. A proper co-ordination between monetary and fiscal policy seems to be the only option for avoiding e negative market response.

What remains to be seen is whether the JPY selling seen on speculation of new policy package can be sustained and furthered through effective easing measures or whether markets will simply be disappointed by another vanilla offering from the BOJ.