There are reports that Bank of Japan (BoJ) governors are considering changing certain key aspects of their monetary policy.
Since 2013, the bank has used a host of unconventional measures to spur inflation to the 2 per cent target – to little avail. Inflation in Japan hasn’t met the 2 per cent level since 2015, and has largely been at or around the zero mark for the past few years.
Recent data has also been disappointing, with June’s core price inflation coming in at 0.7 per cent, below expectations for the third successive month. Excluding food and energy, prices in Japan rose just 0.2 per cent.
There have been various ideas floated that the BoJ is reportedly considering. The least controversial and most likely of these is an adjustment of the bank’s exchanged-traded fund (ETF) purchases.
The BoJ’s quantitative easing program is unique in the developed world in that its purchases extend beyond bonds to equities through ETFs.
But this policy is coming under increasing pressure for its impact on the stockmarket. The central bank is now reportedly a top 10 shareholder in around 40 per cent of Japan’s listed companies. According to the Nikkei Asia review, the BoJ plans to address this problem by switching its investment from ETFs that follow the Nikkei Stock Average to broader indices such as the Topix.
More boldly, some have suggested rethinking or abandoning the 2 per cent inflation target altogether. Mitsubishi UFJ Financial Group chief executive Nobuyuki Hirano argued this week that the BoJ should consider revising its target, given that the economy is improving even without inflation moving higher. The chief of Japan’s largest bank said an aging population means the country has a “lower potential inflation rate and lower potential growth rate.”
It’s a fair point. The likelihood of the BoJ consistently reaching its 2 per cent inflation target is so low that most consider the bank’s professed aim to be little more than lip service – especially as its policy leeway is virtually non-existent, after years of incredibly loose monetary measures.
Back at its April meeting, even the BoJ dropped any reference of their commitment to meet the target in 2019. However, we doubt the bank would change it anytime soon since it clearly has the intention to increase inflation from its current level.
That brings us to the suggestion that we find the most interesting: allowing long-term bond yields to rise. Back in 2016, the BoJ added yield curve control to their extensive monetary arsenal. This has meant the bank is effectively committed to holding 10-year government bond yields down at or around zero, even if inflation starts to pick up.
But now the central bank is reportedly considering easing up on this policy, and allowing long-term bond yields to rise. This raises the question: why would the BoJ want to increase long-term interest rates at a time when inflation keeps undershooting their target?
BoJ members are clearly concerned about the effect their policies are having on the financial sector. In the absence of strong private sector demand for loans, banks make money out of the spread between short-term interest rates, and long-term bond yields, taking deposits at the short end and lending at the long. A flatter yield curve (the difference between long-term and short-term bonds) therefore hurts their profitability. Indeed, that lack of profitability constrains their ability to lend, which then tightens credit availability in the economy.
If the BoJ was to lift its pin on 10-year bonds while also reducing the requirement on banks to put aside capital against private sector loans, the rising yields would hopefully allow banks to offer more credit. The central bank could actually stoke inflationary pressures by doing what looks like monetary tightening.
Given that Japanese wages have proven incredibly unresponsive to the BoJ’s measures so far, allowing the yield curve to steepen could be the thing to pull the country away from deflation.
On its part, the BoJ has cast doubt on rumours they plan to lift their yield curve control at next week’s meeting. Governor Haruhiko Kuroda said he knew of no basis for these reports (which is not exactly a denial).
BoJ watchers also don’t think the bank is likely to announce any large policy changes – bar the details of its equity buying mentioned. But we don’t doubt that this issue is on the minds of the central bank’s policymakers. As Yuji Shimanaka of Mitsubishi UFJ Morgan Stanley Securities says, removal of yield curve control “at the October meeting is a possibility.”
The story is wider than just Japan. Media alarm bells have been ringing for some time now over the flattening and possible inversion of the US yield curve – historically a precursor of recession.
Some have argued the historically unique set-up of the bond market at the moment means these signals are less important because yen and euro excess liquidity has had a large impact on US yields. It may have been even greater than the effect on their own bond markets.
Meanwhile, the effect of ultra-low yields on bank profitability is clear to see. We note the recent torrid share price performance of the global systemically important financial institutions, and believe this is more to do with profitability than credit demand. The combination of strict post-crisis regulation and ultra-low interest rates has sapped bank profits globally.
It’s clear the Japanese authorities are unhappy that the current policy set may be ineffective and that its side-effects may be posing more of a problem. Still, it might have actually been effective and removing some policies could cause the economy and markets to react badly.
Bloomberg has suggested the reports themselves could be the bank’s way of testing that reaction. Kuroda and co will have noted the ripples were rather small, that the currency did not rise sharply, yen bonds moved less than US treasuries, and equities did ok. Bank share prices also did better than ok. If it was a test, we should expect a larger one soon.