The Bank of Japan outlined its new strategy for stoking inflation on Wednesday, steepening its yield curve by targeting the 10-year JGB yield at around 0% and keeping the policy rate unchanged at -0.1%.
It signalled it will implement its ¥80 trillion ($794 billion) increase in the monetary base more flexibly, with no average maturity target. It also indicated its commitment to overshooting the inflation target, becoming the first central bank to formally adopt such a commitment.
The move was followed later the same day by the Fed's widely anticipated decision to leave its own rates on hold.
While the impact of the BoJ's decision on the markets was not particularly dramatic, the long-term implications could be big, particularly if other central banks, such as the European Central Bank, follow suit.
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Viraj Patel, FX strategist at ING, says: “The introduction of a long-term interest rate target – or, more explicitly, yield curve control – could have important implications for the future conduct of developed market monetary policy. More asset-purchasing central banks shifting to a yield curve targeting regime could open the door to greater variance in longer-term G10 rates and a new wave of monetary divergence – monetary divergence 2.0.”
According to Michael Metcalfe, head of global macro strategy at State Street Global Markets, the fact that the flattening of the yield curve has got to a point where it has elicited a policy response could mark the beginning of the end of quantitative easing.
“Just as interest rates have reached their lower bound, asset purchases, in government bonds at least, may have reached their upper bound,” Metcalfe says. “Other central banks, the ECB especially, will take close note.”
The move amounted to a shift in strategy by the BoJ, away from its formal policy of quantitative and qualitative monetary easing (QQE) with a negative interest rate to a new policy of QQE with yield curve control.
Kohei Iwahara, economist at Natixis, says the “BoJ’s policy regime has shifted from targeting monetary base to interest rate.”
Little return
Japan has injected huge stimulus into its markets this year but has seen little return in terms of stoking inflation or weakening the yen, with the currency up around 15% against the dollar year to date.
The scrapping of the target for the expansion of the monetary base and the commitment to keep longer dated yields at zero are intended to alleviate the negative side effects of its former policy. The BoJ's JGB purchases have pushed the 10-year yield down to nearly -0.3%, undermining the profit margins of financial companies and other businesses. By steepening the yield curve, the BoJ hopes to increase the profitability of Japanese institutions.
The bank hopes its strategy will also revive liquidity in the JGB market. It has abandoned its explicit ¥80 trillion target and, with yields higher, it calculates it will need to buy fewer bonds, amid concerns about finite supply.
“There is a growing risk of the central bank failing to meet the annual ¥80 trillion target given that it owns a third of the market already,” says Patel. "Today's decision could be seen as the first step towards an exhaustion of the BoJ's monetary policy toolkit."
Most important is the BoJ's determination to facilitate a rise in inflation. It has been wrestling with the problem of how to achieve its 2% inflation target, while doubts have been growing at the same time about the effectiveness of QE and ultra-loose monetary policy. The BoJ hopes that its commitment to overshooting inflation can help raise inflation expectations.
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Jane Foley, head of FX strategy at Rabobank, says: “Generally it can be assumed that all major central banks would favour an overshoot in inflation since this suggests that when policy is eventually tightened, the resultant sharper increase in interest rates will return to policymakers sufficient leeway to deal with the next economic downturn.”
The BoJ voted for the change with a 7-2 majority, but support for the move was less unequivocal in the market.
John Higgins, chief markets economist at Capital Economics, describes the inflation pledge as “rather meaningless.” And financial services firm Brown Brothers Harriman expressed doubts over whether the change in strategy “increases the chances of the BoJ reaching its inflation target.”
These doubts were reflected in the market. The initial reaction was positive, with yen weakening against the US dollar following the announcement, to trade at 102.6. But the move was short-lived, with the yen strengthening again as markets digested the news. Japanese bonds maturing in one to 15 years saw their yields rise by 20 basis points to 40bp, with longer-dated bonds rising less: the 40-year bond barely responded.
Foley says: “The commitment to overshoot the inflation target has a smoke-and-mirrors element,” being either a pragmatic admission that it cannot hit its target on a specified date, or an attempt to divert attention from the same fact.
Iwahara at Natixis adds that although the announcement could alleviate the negative side effects of QQE on banks’ profit margins and JGB market liquidity, it increases the risks of a stronger yen, especially if the Fed postpones normalisation.
Ana Thaker, market economist at PhillipCapital UK, says: “The country is still far from the 2% inflation target, and this is unlikely to be the last of easing measures we see from the central bank, with a further cut in rates, conventional quantitative easing and fiscal stimulus still on the cards.”
Higgins at Capital Economics also predicts “monetary policy will be eased again before long to the detriment of the yen and the benefit of Japanese equities.”
Same boat
The BoJ's problems are hardly unique, with the European, Australian and New Zealand central banks all in a similar boat, says Foley. “Despite monetary policy easing, the currencies of these central banks have all risen versus the dollar this year. In essence these central banks have fallen foul of the downside pressure that has been exerted on the US yield curve by faltering US inflation expectations and a pushing out of Fed rate hike expectations.”
The move can therefore be seen as a first attempt to recalibrate, rather than abandon, a strategy that has proved controversial, and which many fear is only creating new problems for the market. Other central banks will be watching for clues as to how they can adjust their own monetary policies.
The BoJ isn't ready to let go of its monetary policy experiment just yet, says Patel, “but we’re close to monetary exhaustion.”
Antoine Lesné, EMEA head of ETF strategy at SPDR ETFs, part of State Street Global Advisors, adds: “It may not be viewed as a reduction of the easing stance by the BoJ but rather an enhancement of the policy effectiveness. The market may need to digest this change, but this could strengthen the yen for a while and may put into question the effectiveness of forward guidance.”