What will the Bank of Japan do
The Bank of Japan has announced changes that could allow it to phase out its yield curve control program if economic conditions are favourable. The analysis of Tomoya Masanao, head of PIMCO Japan and co-head of portfolio management of the Asia-Pacific region
The July monetary policy meeting might be remembered as the moment when the Bank of Japan (BOJ) started phasing out its seven-year yield curve control (YCC) program, or at least completed an important step towards his eventual exit from the scene. In our view, the changes to the YCC could help phase out the program as the conditions that led to its creation (persistent low inflation and low growth) ease, without causing a disruptive rise in yields. We also do not expect any significant negative impact on global financial markets from changes to the YCC program. The BOJ said it would make the YCC more flexible while maintaining the 0% target yield level for 10-year Japanese government bonds (JGBs). One of the main policy changes is that the plus and minus 0.5 percentage points around zero will no longer be "hard limits" but "benchmarks" in the bank's market operations. The bank also raised its target level for fixed-rate JGB purchase transactions each business day from 0.5% to 1.0%.
For completeness, the YCC was introduced in September 2016, eight months after the institution surprised the markets by lowering its short-term key rate to -0.1%. Then, in July 2018, the bank defined plus and minus 0.2% as the limits for 10-year JGB yields. To pursue the flexibility and sustainability of the YCC, further changes have been made to the target yield band: plus and minus 0.25% in March 2021 and plus and minus 0.5% in December 2022.
PHASE AWAY FROM THE YCC WOULD HELP MITIGATE ITS INHERENT PROBLEMS
The YCC has had both advantages and disadvantages. The BOJ's unique monetary policy tool has proved effective in helping to suppress long-term real market rates well below neutral real rates, contributing to the depreciation of the yen, the easing of financial conditions generally and thus to stimulate overall economic demand.
However, one structural problem with the YCC is that it could become too much of a stimulus once the BOJ's 2% inflation target is effectively met: Real rates would tend to fall even more with 10-year nominal yields capped and rising inflation expectations, suggesting that policy should be adjusted to be less stimulating, not more. This “procyclicality” is an inherent problem of the YCC, and the July BOJ statement suggests that mitigating this problem is the primary rationale for the bank's decision:
“Japan's recent inflation rates … are higher than expected in the April 2023 Outlook report, and wage growth has picked up … If upward price movements continue, the effects of monetary easing will strengthen through a fall in real interest rates…”.
As time passes and circumstances change, policies that once seemed appropriate often need to adapt. What economists call "time inconsistency" can be destabilizing to markets and the economy, and potentially damage a central bank's credibility. BOJ Governor Kazuo Ueda mentioned this before becoming head of the central bank in April and once again raised the potential problems related to the YCC's procyclicality in the press conference following the July meeting.
The BOJ's risk assessment and its inflation forecasts support the changes to the YCC programme. In its July 2023 outlook report, although the bank's forecast for consumer price index (CPI) inflation, excluding fresh food, was lowered slightly to 1.9% year-on-year for the for fiscal 2024 and held unchanged at 1.6% for fiscal 2025, the bank identified an upside risk to 2024 inflation and removed downside risk from its 2025 forecast.
AN ELEGANTLY DESIGNED PROGRESSIVE ELIMINATION
In our view, the retention of the 0% target for 10-year JGBs with plus and minus 0.5% benchmarks (no more hard limits) and the new 1% upper limit represent an elegantly designed phase-out for the YCC.
The limited history of central banks abandoning rate cap policies suggests that this move can be destabilizing. Governor Ueda recalled the examples of the US Federal Reserve (Fed) in 1951 and the Reserve Bank of Australia (RBA) in 2021.
The YCC's seemingly complicated new structure may be far less disruptive; we believe the BOJ may have addressed the procyclicality problem before it becomes unmanageable. The BOJ would allow (or even welcome) an increase in 10-year JGB yields above 0.5%, provided that the increase in the nominal yield is due to an increase in inflation expectations consistent with the inflation target of 2% and/or a healthy rise in real rates reflecting stronger economic growth. Under these conditions, the YCC could be automatically eliminated with little repercussions on the markets and the real economy. Or, in an unfavorable economic scenario where inflation rates fall and don't rise back to the 2% target, the YCC could simply continue and suppress yields downwards if needed.
In essence, with the July announcement we believe that the BOJ has likely succeeded in limiting the risk of its policy being pro-cyclical and destabilizing in a successful inflation scenario, while maintaining a powerful easing tool with the same objective as yield for an undesirable scenario of a return to deflation.
SHORT-TERM REFERENCE RATE UNCHANGED
The Bank of Japan kept its short-term reference rate unchanged at -0.1%. The bank likely needs more data to be sure its 2% inflation target has been sustainably and stably met (a condition of its forward guidance) before considering a change. However, the market may soon start testing the BOJ on the short-term policy rate. Inflation dynamics appear to be changing, including in Japan.
IN CONCLUSION
The BOJ's July decisions could likely result in a phasing out of the YCC. The bank would allow JGB yields to rise, if gradual and consistent with growth and inflation, with a new cap at 1.0%. The fear is that JGB yields could hit 1% too soon, with the drive to rise further. We think JGB yields are likely to remain subdued: If yields were to rise close to 1%, we expect strong domestic demand for Japanese duration to be sufficient to keep yields there for now, at least until the The BOJ's 2% inflation target will eventually not be met.
We also do not expect the BOJ's changes to the YCC to have significant negative spillovers to global financial markets. Many Japanese investors have already offloaded a large amount of foreign bonds, as their currency hedging costs have risen as the Fed and other central banks raise interest rates. This should help limit domestic investors' further appetite to sell foreign bonds to buy Japanese bonds.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/cosa-fara-la-banca-del-giappone/ on Sun, 06 Aug 2023 05:38:01 +0000.