BOJ: Eyeing Autumn

Published on July 23, 2018

In response to questions by reporters at this weekend’s G-20 meeting in Buenos Aires, Bank of Japan Governor Haruhiko Kuroda insisted he knew “absolutely nothing about the basis” for reports furiously circulating in the financial press that the BOJ Board will be discussing potential revisions to its Yield Curve Control (YCC) policy at its upcoming two-day Monetary Policy Meeting on July 30-31.

*** While Kuroda may deny knowledge of the basis for these press reports, we continue to believe a revision to the BOJ’s YCC policy pegging Japanese bond yields from zero to 10 years out at -0.1% to 0.0% is highly likely, and relatively imminent (see SGH April 20, 2018; “Japan: BOJ Shifts and Abe Pressure”). ***

*** In order to provide relief to the banking sector, we expect the BOJ will most likely lift the current 10-year JGB cap of 0.0%, while keeping a peg in place on the 5-year JGBs to ensure rates along the curve do not go up too sharply. If conditions allow, we believe the groundwork is being laid for a move most likely in autumn, perhaps as soon as at the October MPM meeting when the next Outlook Report is also to be published. ***

*** From what we understand, the rationale for a YCC change is methodically and deliberately being laid out by an internal review of Japan’s disinflationary problem that will be discussed at the upcoming meeting, which will point to structural, non-monetary policy causes for persistently low inflation in Japan. We believe Kuroda’s semi-denials this weekend reflect simply a continued hesitation over surprising markets too quickly, and the need still to meticulously make the policy argument for such a move, especially with inflation data expected to be revised downwards yet again at next week’s MPM meeting. ***

For all the “non-denial denials,” it seems it is Kuroda, himself, who is slowly guiding his Board towards a revision of the 10-year yield target. When he decides the time is ripe, the rest will follow.

Making the Case for Change

Ever cautious, Kuroda, and his fellow BOJ Governors, remain concerned that too rapid a shift towards a loosening of the long end of the curve will generate excessive turbulence in financial markets, including too sharp of a spike in JGB yields, rise in the yen, or drop in equity markets. And so the message still needs to be trickled out.

But perhaps more importantly, in order to make the case credibly to manage that message, the BOJ still needs to articulate how a revision to the YCC is not an exit from ultra-loose monetary policy, all the more so with inflation data continuing to disappoint, and expected to be revised downwards yet again in the quarterly Outlook Report that will be released at next week’s MPM meeting.

We expect the adjustment to the current structure of the yield curve will, therefore, in time be presented as a mild steepening designed to ease the transmission mechanism of monetary policy into the real economy through a stronger, and more profitable, banking system – especially when it comes to the regional banks.

And so higher rates on the long end might therefore not result in a net tightening of overall financial conditions, or if it does, it will be one in which higher nominal rates should arguably be offset at least in part by increased bank profitability and lending.

Building Consensus

But before that can happen, the more dovish arguments for a continuation of current policies to hit what is clear to most is a highly elusive 2% inflation target need to be debunked, and that is where the ongoing review of factors driving Japan’s low inflation rate will come in.

The Policy Board started that discussion at its June meeting, and will continue it at the July 30-31 meeting next week. We suspect the review will pointedly include an assessment of factors depressing inflation that are un-related to monetary policy, such as Japan’s shrinking population, global competition, and the rise of internet retailing.

As these are factors directly working against the BOJ’s efforts to push inflation to 2% through ultra-loose monetary policy, the merits of the current yield curve structure, the argument goes, should therefore be reassessed against its potential de-merits, mainly the deterioration of profitability in financial institutions.

Step by step, as in the boiling of the frog, the BOJ has been making the case for such a shift.

In March, the BOJ released a study outlining how a weakened banking sector could undermine its efforts at monetary policy stimulus, followed by a report warning of financial stability risks that could emanate from pushing banks, starved of interest income, too deeply into lending to non-profitable businesses.

And then, in a clear reach for policy flexibility, on April 27 the BOJ deleted the timing of “around fiscal 2019” for achieving the 2% inflation target entirely from its “Outlook for Economic Activity and Prices.”

Then perhaps most telling, on May 15, in response to a question at a Committee on Audit and Oversight Administration of the Lower House of the Diet, Kuroda remarked “it’s not as if we [the BOJ] will defend the 10-year yield target of around zero percent at all costs.”

The case by the BOJ for a reassessment of the risk reward of the current policy appears, to us, to be clearly, methodically, and broadly being made. It is the economic conditions and market timing, at this point, that seem increasingly to be the tactical question at hand.  

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