The BoJ’s New Monetary Experiment: Riddled with Inconsistencies

  • Adding to its already wide-ranging arsenal of of monetary policy tools, the BoJ last week introduced yet another feature: “QQE with yield curve control”. In addition to the short term rate, the new regime aims to peg the long term interest rate (10yr) as well.
  • However, targeting interest rates is inconsistent with controlling the quantity of money. What is more, the policy may require asset sales and thus run counter the original policy objective.
  • It reveals a sensitivity to banking sector concerns which conflicts with the BoJ’s official price targets. While it may allow the BoJ to delve deeper into negative rates on the short end, the move also undermines the process of asset price reflation.

In its repeated attempts to combat Japan’s endemic deflation, the BoJ pioneered quantitative easing (QE) in the modern era, ventured into purchases of non-government assets early on and was one of the first central banks in the post-GFC era to experiment with negative interest rates. It has now expanded its arsenal further, to the point where its new targets represent a shift to a new policy regime, if implemented strictly.

The BoJ announcement contained two main elements: First, a commitment to aim to overshoot the 2% inflation target until core CPI exceeds the 2% level in a stable manner. This is reminiscent of the recent policy discussions at the Jackson Hole meetings over the appropriateness of the monetary framework in addressing the next recession (e.g. doubling the inflation target to lower the real interest rate). However, as described elsewhere, we regard this not only as ineffective when the current inflation target has not been met, but worse yet, as potentially damaging.

jp-yccThe second, more important element was the shift to the so-called yield curve control” regime. Here, the BoJ envisages targeting both short and long rates (the overnight rate on a part of bank balances, currently at -0.10% and the 10-year JGB yield, currently just below zero). The BoJ did not alter the size of its asset purchases of JPY80 trn per year or change its short term rate, but announced a yield target for 10yr JGBs of 0% (it also removed the guideline for a 7-10 year average maturity of its purchases to give itself more flexibility). The objective of the new regime ostensibly is to control not only the level, but also the slope of the yield curve with the aim of supporting banking sector profitability. The chart shows not only the long-running, secular flattening of the yield curve. but also how it compares to the German and US curves.

Despite these radical changes, markets took a dim view of the move (the yen rallied over 2% in its wake). This likely reflected one or more of the following issues:

  • No Easing: The BoJ did not announce a change in the monetary stance but in the monetary regime, which does not, per se, equate to an easing. Yet, an easing was what had been expected, so market participants were disappointed.
  • Less Portfolio Rebalancing: The theoretical grounds for the move are muddled. The previous QQE policy (like QE operations elsewhere) was built on the idea that BoJ purchases would liberate bank balance sheets, allowing banks to engage in more risky operations (e.g. lending to the private sector). The new policy stands in conflict with that objective as it guarantees banks a minimal (non-negative) return on government securities and thus provides a disincentive for them to push into riskier markets.
  • Quantitative Tightening? Current 10yr yield levels are at -0.07% (up from -0.28% in late July), that is, marginally below the BoJ’s new target. As long as such a situation persists, getting long term yields near the target level requires the BoJ to sell JGBs, the opposite of its proclaimed policy – with all the attendant consequences (i.e. reversing the portfolio balance effect).
  • Price versus Quantity: Central banks typically set targets for a chosen (base) interest rate and conduct open market operations with a view of achieving this target. Committing to a price target implies adjusting the quantity accordingly. The BoJ muddled its message by introducing a price target (the 10 year yield) while maintaining a quantitative target of JPY80 trn JGB purchases per year. This is inconsistent: if the BoJ intends to target long term yields, it will have to abandon the quantity target for its purchases.
  • Multiple targets: That the BoJ cares more than about monetary variables became clear when it launched a system of tiered deposit rates at the time it introduced its negative rate policy. The measure was clearly adopted with an eye towards the banking sector. Similarly, the desire to preserve a certain skew in the yield curve is a measure designed to ensure a degree of banking system profitability.

In theory, the BoJ has given itself more policy tools – the long and the short term policy rate – and could act on either one at any given time. In reality though, it has revealed a preference for a yield curve spread of at least 10bps, so any move in one rate will condition a move in the other (under current circumstances). The upshot is that last week’s move which didn’t change the BoJ’s monetary stance, is likely nothing more than a precursor to more. The BoJ is set to ease further, but it is likely to cut long term rates by less than short term rates or leave them unchanged, thus maintaining or steepening the slope of the curve.

While it is possible that the current yield target can be reached with JPY80 trn of purchases or less per year, the BoJ will effectively have to cede control over the monetary base (and thus the size of its balance sheet). In turn, this implies that support for risky assets is weakened: on the one hand, quantitative easing has been curtailed, limiting the portfolio balance effect, and on the other hand, capping yields at 0% limits losses on government bonds and thus reduces the relative attractiveness of equities.

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