Japan PM’s Political Doom Loop Worsens Her Fight with Markets

The current state of Japan’s economy is a perfect storm of politics, markets, and policy failures that threatens to engulf Prime Minister Sanae Takaichi’s government. The recent slump in her approval ratings has exacerbated the problem, making it increasingly difficult for her administration to implement its promised tax cuts and fiscal stimulus without triggering further market volatility.

Takaichi’s troubles began when she took office last year with a pro-growth agenda that clashed with investor concerns about fiscal discipline and central bank independence. This communication challenge has led to unwanted market volatility, which in turn makes policy implementation more difficult. The prime minister’s decision to cut the 8% food levy by two years, despite reservations within her own party, is a case in point.

The move will likely come as little surprise, but the lack of funding clarity could further upset bond markets. Analysts say this will only solidify the premier’s determination to cut tax and boost investment, jolting markets while not doing so would hit her popularity. The dilemma ahead of key policy meetings by the U.S. Federal Reserve and Bank of Japan is particularly daunting.

The government’s communication strategy has shifted from yen jawboning to giving the bond market more clarity. Finance Minister Satsuki Katayama’s repeated threats of “decisive” action have kept markets on edge but failed to give a sustained boost to the sagging currency. The record $72 billion intervention conducted between late April and early May did little to arrest the yen’s downtrend, raising questions about the effectiveness of such measures.

Takaichi and Katayama are pitching the administration’s expansionary fiscal policy as boosting Japan’s growth potential, thereby helping enhance the appeal of the yen and JGBs. However, markets remain unconvinced, with yields on track for further rises amid looming prospects of bigger debt issuance that would strain Japan’s already worsening finances.

The administration faces two big headwinds: slumping approval ratings and declines in yen and JGBs caused by eroding market trust in its fiscal policy. Former BOJ board member Takahide Kiuchi is right when he says that to recover market trust, the administration needs to show with specific facts and figures its focus on fiscal discipline.

The prime minister’s determination to break Japan’s “excessive fiscal tightening” with big investment is admirable but may not be enough to placate markets. The sliding approval ratings would only solidify the premier’s determination to cut tax and boost investment, jolting markets while not doing so would hit her popularity.

It’s a classic case of politics vs. economics, where the prime minister’s pro-growth agenda clashes with investor concerns about fiscal discipline. Takaichi has tried to explain how her administration is mindful of the need for fiscal discipline but her policies themselves won’t change much, leaving little hope in bond markets that things could change.

The yen could see more volatility this week when the U.S. Federal Reserve and Bank of Japan hold policy meetings. While both are seen keeping rates steady, hawkish hints from the Fed could accelerate yen falls versus the dollar. The administration needs to show a clear plan to address these issues and restore market trust before it’s too late.

The outcome is far from certain, but one thing is clear: Takaichi’s government is caught in a vicious cycle of politics and markets that threatens its very existence. A bold and decisive response from the prime minister and her team is needed to break this cycle and stabilize Japan’s economy. Anything less would be a recipe for disaster, not just for Japan’s economy but also for its politics.