This weekend’s general elections brought the Liberal Democratic Party of Japan (LDP) back into power. After losing majority to the Democratic Party of Japan for a brief 3 years, the party that has ruled the country for more than half a century is now back at the helm. In 2009, the people of Japan were desperate for change but after 3 years, Prime Minister Noda failed to revive the economy and has left Japan embroiled in a testy diplomatic dispute with its most important trading partner, China. As voters took to the polls, there was a general sense of frustration with the DPJ’s lack of experience and this dissatisfaction translated into overwhelming support for the LDP. It is out with the new and in with the old as the people of Japan hope that the old guard will be tougher on China and more aggressive on the economy.

For the past month, investors had been slowly pricing in a win by Shinzo Abe with stocks soaring and the Yen collapsing. When the markets opened on Sunday, USD/JPY spiked higher and rose to its strongest level since April 2011. The LDP did not win enough seats for a two-thirds majority (they secured only 294 seats) but a coalition with the smaller New Komeito Party, who won 31 seats will achieve this goal and allow the DPJ to pass bills without the support of the upper house. Having a two-thirds majority is extremely important because division between the upper and lower houses blocked progress on the economy for the past 5 years and is the main reason why Noda was forced to call early elections.

What LDP Win Means for the Bank of Japan

LDP leader Abe pledged to be tough on China and implement more pro-growth measures such as easier monetary policy and big fiscal spending. The question now is whether Abe will temper his stance now that the LDP has returned to power. With Bank of Japan Shirakawa’s 5 year term ending in April, it may be more complicated to change BoJ law and force the central bank to adopt a higher inflation target than to nominate a candidate that supports easier monetary policy. In the long run, maintaining BoJ independence and repairing ties with their neighbors and key trading partners is essential to the country’s economic prosperity and viability. At the beginning of this month, Abe once said, “If I become prime minister, I will not comment on specific monetary policy measures, which should be decided by the Bank of Japan, I am commenting on specific measures because I am in opposition.” So while we cannot ignore the strength of the rally, we remain skeptical that the gap will be filled and USD/JPY will slip back to 83.40.

There is a very good chance that Abe will instill a more dovish monetary policy committee in April 2013, but a LDP win doesn’t change the need for more stimulus. Japan is still in recession and a planned sales tax hike in 2014 could limit the recovery. Public debt is twice the size of GDP, global growth remains weak and the country’s $340 billion trade relationship with China is still at risk. Therefore, regardless of who won the elections, the Bank of Japan still needs to consider easier monetary policy. The BoJ is widely expected to increase asset purchases by another 5 to 10 trillion yen but BoJ Governor Shirakawa could still choose to assert the BoJ’s independence by forgoing a move this week and waiting until the New Year. In the meantime, the sharp sell-off in the Japanese Yen provides support to the economy and takes some of the pressure off the Bank of Japan.