The message was clear: The Bank of Japan (BOJ) finally admitted that its current policy framework hit the limit. Disappointed? Well, at least the BOJ’s decision on 29 July provides some relief for Japanese banks, insurance companies and pension funds.
In concluding its two-day monetary policy meeting, the BOJ “only” increased its equity ETF purchases and expanded its U.S. dollar-funding facility, both of which are “qualitative” parts of its so-called Quantitative and Qualitative Easing with a Negative Interest Rate Policy (QQE+NIRP). Neither additional QE (in the form of purchasing Japanese Government Bonds) nor further rate cuts from the current negative 10 basis points (bps) on the interest on excess reserves (IOER) were made.
Relief for Japanese financial institutions
The current policy framework is already neither effective nor sustainable and therefore needs to be altered. Since the surprise introduction of the BOJ’s NIRP on 29 January, the JGB curve has flattened massively. While the cut in the IOER was only 20 bps, the 40-year JGB yield fell by almost 100 bps to 0.06% earlier this month, evidence of how powerful the combination of QQE and NIRP has been in collapsing the yield curve. The BOJ was (until now) operating with benign neglect regarding the costs to financial institutions of this dramatic move in the yield curve, emphasizing instead the intended economic stimulus impact of lowering long-term rates.
Extraordinarily low yields and flat yield curves are the least favorite recipe for banks and any other financial institution: Margins get squeezed as reinvestment yield declines while liability costs, or promised returns, cannot be lowered. The BOJ’s decision to keep the quantity (the JGB purchase amount) and the level of negative rates unchanged is a strong signal that the BOJ is finally admitting the large costs associated with its current policy framework.
More welcome news for Japanese banks
The expansion of the BOJ’s U.S. dollar-funding facility should also be welcomed by Japanese banks and other financial institutions. They have been pushed to invest in “the outer circle” (e.g., U.S. Treasuries, corporate bonds and loans) as alternatives to their own domestic bond market where yields have become unattractive. Although encouraging financial institutions to take more risk was in part an intended result of the BOJ’s policy, this has reached a limit. The cost of U.S dollar funding, specifically the currency hedging, has soared for Japanese investors as their demand for funding has increased dramatically while the supply has been decreasing amid the post-crisis balance-sheet constraints of Western banks and the effects of imminent money market fund reforms in the U.S.
The good news for Japanese financial institutions is not limited to the BOJ’s decision on QE and interest rates. The BOJ also said in its statement that the bank would conduct a comprehensive assessment on the effectiveness of its current policy. There is hope that the bank will make a very objective assessment on benefits, costs and risks of its policy and make appropriate adjustments for effectiveness and sustainability.
BOJ success so far
To be fair, the BOJ has made some good progress since Governor Haruhiko Kuroda took his position in March 2013: The jobless rate has decreased to an extremely low 3.1%. Inflation is still low, but at least deflation is behind us. However, the returns on the BOJ’s policy have clearly diminished as the long end of the JGB yield curve has declined to such an extraordinarily low level.
Perhaps it is time for monetary policy to move to a back seat and let fiscal policy take the wheel. We shall see.