Japan's Deflation Battle—Why This Time Is Different

Shinzo Abe, incoming Prime Minister of Japan.
Yoshikazu Tsuno | AFP | Getty Images
Shinzo Abe, incoming Prime Minister of Japan.

While only time will tell whether Japan's incoming Prime Minister Shinzo Abe wins the war he has declared against deflation, one thing is clear, say analysts, the central bank will be pushed to be far more aggressive than it has ever been.

"They (Abe and his Liberal Democratic Party) have all the power that they want," Nicholas Smith, director and strategist with CLSA in Tokyo said after the opposition LDP's landslide victory over the weekend.

"He's talking aggressive monetary policy, fiscal policy and a weakening of the yen. The important thing is not whether they will execute and whether they will be able to execute, but just how far they will go with this. I think we should be frightened about how much they do, rather than how little," Smith added.

The Bank of Japan (BOJ) has so far eased policy four times this year by expanding its asset buying program, which currently stands at 91 trillion yen ($1.1 trillion), but these measures have been ineffective in boosting the economy struggling with recession, reversing deflation and weakening the yen.

(Read More: Aggressive Easing Wrong Medicine for Japan: Roach)

In his election campaign Abe, who will be serving as prime minister for the second time after leaving office 5 years ago, pledged to pressure the BOJ to ease more aggressively in a bid to inject new life into the world's third-largest economy. Abe is aiming for a higher inflation target of 2 percent instead of the current 1 percent goal set by the BOJ.

In the month before the December 16 elections Abe's comments have lifted investor sentiment, with the Nikkei up more than 12 percent. Talk of aggressive easing also saw the safe-haven yen shed 5 percent against the U.S. dollar.

(Read More: Japan's Next PM Abe Must Deliver on Economy, Cope With China)

On Monday, a day after the LDP surged to power winning a majority in Japan's lower house of parliament, Japanese shares hit an eight and a half month high, while the yen touched a 20-month low.

The BOJ is meeting next on Thursday and may expand its asset-purchase program by another 5 to 10 trillion yen, Reuters reported. The last time they eased was in October, and then too they had expanded their bond buying by about 10 trillion yen.

(Read More: BOJ Likely to Ease Again Next Week Via Asset Buying: Sources)

Whatever the outcome of Thursday's meeting, the long-term trend is clear. The BOJ will not be as cautious as it has been, said Ray Attrill, co-head of forex strategy at National Australia Bank in Sydney.

"I think the days of the BOJ being able to maintain its current cautious stance towards monetary easing is certainly numbered," Attrill said. "The new government has the right to appoint the new governor and the two new deputy governors whose terms expire next March and April, respectively. And we have two BOJ board members who have been appointed because of their explicit support for much more aggressive policy earlier this year."

Jesper Koll, managing director and head of Japanese equities at JPMorgan Securities Japan, agreed that Abe will have a lot to prove this time around as prime minister. He is expected to be voted in by parliament on December 26.

"This man Abe is driven, he's focused. He's on a vendetta to prove to the world. And the super-majority they got, this landslide victory sure is a very strong mandate. Watch out. An all-out attack on deflation is on its way to Japan," Koll added.