Posted on August 04, 2018

Japan may have been usurped by China as the world’s second largest economy some years ago, but it remains of critical importance to global economy. For starters, it still accounts for a substantial 4.5% of global GDP at purchasing power parity as per the International Monetary Fund estimates.

Second, Japan’s financial markets play a major role in the global economy as the Japanese Yen (JPY) a key reserve currency. Japan’s government bond (JGBs) market is also the largest global sovereign bond market ensuring that JGB yields operate as a key anchor for global interest rates. Lastly, Japan has long been the vanguard of global monetary policy developments. The Bank of Japan (BoJ) has been battling deflation for over two decades and was the first major central bank to hit the zero bound (policy rates dropping to zero) and also the first to adopt quantitative easing (QE): the large scale purchase of government securities.

Under the leadership of Governor Kuroda over the last five years, the BoJ has continued to innovate in its epic, but still unsuccessful, attempt to lift Japan’s CPI inflation back to its 2% target. First, the BoJ has directed some of its asset purchases towards buying equity ETFs. While other central banks have purchased corporate debt, no other central bank has moved this far up the risk spectrum in terms of its asset purchases. Second, in another unprecedented move for a central bank in the modern era, the BoJ adopted what it terms ‘yield curve control’ or ‘YCC’ in the summer of 2016. Under YCC, the BoJ now targets the 10-year JGB yield, pegging it within 10bp of zero. The short-term policy rate - the overnight deposit rate that banks must pay on their reserves held at the BoJ - is fixed at -10bp, effectively ‘taxing’ banks for excess reserves.

YCC is an important departure as ‘orthodox’ QE usually takes the form of central banks targeting a certain amount of asset purchases in order to hit a certain size of the central bank’s balance sheet. Under YCC, however, the BoJ targets the price of JGBs with the quantity of purchases (and so the future size of the BoJ’s balance sheet) required to peg 10-year yields varying according to market conditions. The success of YCC can only be described as mixed. On the plus side, the BoJ has successfully pegged 10-year JGB yields close to zero over the last two years, providing an important anchor for global interest rates. Furthermore, YCC has allowed the BoJ to gradually scale back its JGB purchases from a peak run rate of JPY80 trillion annually to around JPY45 trillion.

On the debit side, however, CPI inflation remains far below its 2% target. Latest data show core inflation (excl. food & energy) running at a feeble 0.2% y/y in June and showing little sign of accelerating despite Japan’s historically tight labour market. The longer it continues, YCC also raises mounting concerns over the health of the financial system. With little credit growth in the Japanese economy, the interest from their JGBs holdings is a key source of commercial banks’ income. Yields near zero depress income while the effective ‘tax’ of 10bp on their overnight deposits at the central bank further gnaws at banks’ profitability.

Combined with the backdrop of the US Federal Reserve’s now well advanced policy normalisation, speculation had begun to build up that the BoJ could signal an exit from YCC following its latest policy meeting on July 31st. 10-year JGB yields moved up to their 10bp ceiling, forcing the BoJ to step up short–run purchases to hold the line. The tremors were felt globally with even a 5bp rise in JGB yields spilling over into higher US Treasury yields. In the event, the BoJ dashed expectations for any major policy shift by maintaining the negative short-term interest rate of -0.1%. Importantly, however, it will now apply to fewer reserves to help cushion the long-term impact of the policy on commercial banks’ profits. The centre piece of YCC - the 10-year JGB yield target of zero - was also maintained although the BoJ announced that it will now tolerate deviations up to 20bp.

But to ensure that this modest increase in flexibility around its yield target was not misinterpreted by markets, the BoJ also emphasised that it intends to keep both short-term and long-term rates pegged at current levels for an “extended period of time”. Combined with deep cuts to its CPI forecasts, which now do not envisage inflation reaching 2% until at least 2021, the BoJ hopes to quash expectations of policy normalisation and signal that it is ready for an even lengthier battle to try to generate 2% inflation. JGB yields initially pulled back and the JPY weakened against the USD following the announcement.

There would seem to two standout conclusions from the BoJ’s decision. First, its ultra-radical monetary policy settings look here to stay for some time. Real change would seem unlikely until at least 2020. Accordingly, the Bank of Japan’s policy settings should progressively decouple from its global peers (US Fed, ECB), as these central banks move away from crisis-era policy settings. A weaker JPY is the logical outcome. Second, the 10 year JGB yield should remain pinned relatively close to zero for the foreseeable future, helping cap the upside for US and European long term bond yields.

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