Is the Bank of Japan beginning to normalise monetary policy?

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On 9 January, the trimming by the Bank of Japan (BoJ) of its purchases of long-term bonds seems to have provoked speculation that it may be part of a generalised retreat by G3 central banks from their non-conventional monetary policy. As US bonds sold off in recent days, some pundits are even talking more broadly of a ‘new era for fixed income’. Given the degree to which central banks control bond markets via their asset purchases, it is critical to understand what’s behind the BoJ’s most recent policy actions.

The recent background to the BoJ’s non-conventional policy measures

Japan has been battling for years to escape a deflationary spiral. Five years ago, the BoJ, acting in concert with the Japanese government, declared its intention to pursue policies to raise inflation to a target of 2%. Since then it has introduced an array of unconventional policy measures:

  • January 2016: a modestly negative rate on new bank reserves
  • September 2016: the BoJ introduces yield curve control (capping 10-year bond yields at 0%) and even makes an ‘inflation-overshooting commitment’ – to buy assets until inflation “exceeds the price stability target of 2% and stays above the target in a stable manner”.

All these efforts failed. The year-on-year change in Japan’s inflation rate as of November 2017 was just 0.6% for headline inflation and 0.1% excluding food and energy.

After saying ‘No tightening’, the BOJ trims its purchases on 9 January

There had been speculation for some time that a change in BOJ policy was on the way.

In November, BoJ governor Haruhiko Kuroda twice mentioned a ‘reversal rate’ – the risk that the BoJ’s policy rates are so low that they are not actually stimulating the economy because banks have become unprofitable and are no longer lending – and markets began to wonder if the BoJ was debating some change in its current yield curve control (YCC) policy.

Any suggestion that the BoJ could be planning even a very tentative step toward exiting easy monetary policy would have major repercussions for financial markets. The BoJ was forced to reassure markets that no policy changes were imminent. Indeed, in December, the BoJ governor again signalled that no monetary policy tightening was imminent.

However, on 9 January, the BoJ offered to buy JPY 190 billion of Japanese government bonds (JBGs) with 10 to 25 years left until they mature, a reduction of JPY 10 billion from the central bank’s previous tender for such bonds on 28 December.

Similarly, the central bank also reduced the amount of JGBs with 25 to 40 years to maturity by the same amount, to JPY 80 billion. No official announcement was made, this was simply an adjustment to the BoJ’s purchases.

The view from Tokyo: how we interpret the BOJ’s actions

Our view here in Tokyo is that investors are over-extrapolating if they see the BoJ’s 9 January actions as precursors to a broader policy change. Indeed, we have several reasons for being a little bemused at the somewhat dramatic reaction to the BoJ’s minor reduction in bond purchases:

  • Rising tax revenues and some technical issues concerning its refunding requirements mean that the issuance of JGBs scheduled for the fiscal year 2018 is considerably lower than in 2017. As the BoJ already owns about half all outstanding JGBs, supply is getting very tight. So, aside from any considerations about monetary policy, the BoJ has no choice but to reduce its purchases of bonds because there are simply not enough JGBs left to buy.
  • The timing of this tapering in the purchases of long-dated bonds was a little surprising – as the BoJ announces its bond purchase schedule at every month end, it might have been better to make its move towards the end of December to warn the markets. But other than in its timing, the tapering was very much expected among JGB specialists here in Tokyo, which is why most people I talked to here were surprised about the extent of the reaction in other markets (e.g. foreign exchange, US Treasuries).
  • For the technical reason I have outlined – a shortage of bonds to buy – the BoJ will likely continue to taper in the course of 2018, but this does not in itself represent a ‘policy change’, i.e. a possible upward tweaking of the YCC target, currently set at ‘0% for 10-year JGB yields’.

Could we envisage the BoJ making a real change to its non-conventional policy measures?

One can never say never, but in our view, any change in the BoJ’s policy would depend on two factors:

  • Firstly, inflation. For the BoJ to raise the YCC target, we think evidence of an increase in inflation, preferably from higher wages rather than just higher oil prices, is required.
  • The second factor is the health of Japan’s financial system. Japanese small/medium-sized financial institutions are currently in a critical situation in terms of their earnings. In Japan, credit demand is weak so small banks are obliged to invest liquidities in the bond market. With a negative policy rate and a flat yield curve, they cannot make enough money from bond investments. At some future point, the BoJ might be forced to raise the YCC target to prop up these small banks even if inflation is still too low. It may be that the BoJ will be forced into declaring that its 2% target for inflation is unrealistic. In our view, the BoJ would settle for a stable inflation rate of 1% on an ex-energy basis.

What is likely to happen next?

The first major item on the agenda is the nomination (or re-nomination) of the BoJ’s next governor. The consensus view in Tokyo is that Governor Kuroda will be re-nominated for a second five-year term, but we also think there is a chance that Kuroda may voluntarily step down.

Judging from his recent comments, we think Governor Kuroda has finally realised the extent of the negative side effects resulting from excessive monetary easing. If we are correct Kuroda may either; (i) step down and leave the policy adjustment to his successor; or (ii) gradually change his current policy stance during his second term by allowing the yield curve to bear-steepen.

The timing of the policy change depends on the two factors mentioned above, i.e. the inflation situation and the earnings environment for smaller banks.

In our view if there is any sort of meaningful rise in inflation in the coming months, we may see, or at least the market may discount, an upward tweaking of the YCC target towards the end of 2018.

The tail risk scenario to our view would be the nomination of an aggressive reflationist as the new governor of the BOJ, who disregards the risk of turmoil in the Japanese financial system and aggressively accelerates additional easing measures.

The Japanese parliament session resumes on 22 January, after which we may hear at any time about who is to be the new BoJ governor.

This article was written by Naruki Nakamura on 11 January 2018 in Tokyo

Previous articles on this subject:

Japan: a two-sided economy, written on 06/07/17

GDP growth in Japan on a positive roll but no change to the big picture, written on 22/05/17

Four straight quarters of Japanese growth – it’s been a while, written on 13/02/17

A new twist in the saga of Japan’s unconventional monetary policy, written on 22/09/16

Naruki Nakamura

Head of Fixed Income Japan

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