To much anticipation, the Bank of Japan announced changes to its policy framework on 21 September based on its “comprehensive assessment” of its Quantitative and Qualitative Easing with a Negative Interest Rate Policy. While the outcome of the bank’s self-assessment was in line with what we had already heard from Governor Haruhiko Kuroda and Deputy Governor Hiroshi Nakaso in their recent speeches, the policy changes that the bank made were not exactly what the market was expecting.
The consensus expectation was a combination of some form of additional easing and a technical “tweak” to the QE (for example, shortening the average maturity of the Japanese government bonds, or JGBs, to be purchased). Instead, the BOJ made a policy “regime shift” from base-money targeting to yield-curve targeting. (For some, this did not come as a surprise. See our recent commentary.) The BOJ from now on will no longer target a base-money increase at an annual pace of ¥80 trillion but will target two specific interest rates: the overnight rate on part of excess reserves and the yield on the 10-year JGB. The average maturity target of seven to 12 years for the JGB purchase operation is now abolished; instead, the fixed-rate fund-supplying operation will be extended up to 10 years and will be used, along with the JGB purchasing, to control the yield curve.
Rationale for the BOJ’s policy regime shift
Why did the BOJ move to a yield-curve targeting regime?
First, the BOJ has hit the limit on how low and flat the yield curve should be from a policy effectiveness point of view. As the central bank admitted in its self-assessment, excessive flattening of the yield curve starts to be more harmful than helpful for the economy, as it can damage financial intermediation. Also, in Japan, the economy is most sensitive to changes in the short- to medium-term parts of the yield curve. So the neutral yield curve should be steeper, and therefore the bank should be able to reduce the long-end JGB purchase amount and “taper” the QE without damaging the economy.
Second, the BOJ is also inching closer to a practical limit on how many more JGBs it can buy, considering the fact that banks and insurers will not sell the JGBs they need to hold for collateral and liability-matching purposes. Third, and related to the second point, the BOJ’s war against deflation will be a very long one and hence the easing program will need longevity. The central bank has opened a new chapter by targeting the yield curve against the New Neutral yield curve and will make a step toward “stealth tapering” of its QE.
Importantly, will the yield-curve targeting work better in helping the BOJ achieve its 2% inflation target? Not very likely, in our view. The expected transmission mechanism of policy will be the same under the new regime. Stealth tapering of the QE should help delay hitting the practical limit on the QE operation, but it still runs the risk of being viewed negatively in the markets, particularly because the tapering would happen before the policy mission is achieved. It should also be emphasized that the BOJ alone cannot win the deflation war; the monetary authority’s efforts need an assist from the government in the form of structural policy responses to lift potential growth rates.
Japanese bank stocks and the Nikkei Index rallied immediately after the BOJ’s announcement. However, the sustainability of the risk-asset rally is not certain. The BOJ’s decision is evidence of its policy exhaustion. The BOJ will likely remain super-accommodative but will no longer be able to take the lead: It is sneaking into the back seat.
Tomoya Masanao is PIMCO’s head of portfolio management in Japan and a frequent contributor to the blog.