While there are all sorts of interpretations and opinions concerning the series of policies announced by the Bank of Japan on July 31, I view these measures as reinforcing the de-facto normalization policy that has been pursued by the BOJ for some time.
A De-Facto Normalization 2.0
The series of policy measures announced by the BOJ on July 31 were touted as “Strengthening the Framework for Continuous Powerful Monetary Easing”, suggesting an enhancement of the current quantitative easing program, but I believe they very much represent a de-facto normalization policy, one that’s intended to lessen the side effects caused by the bank’s longstanding and swollen easy money policy. De-facto normalization refers to a policy that is one of normalization in its substance but is officially stated to be something else. Given that inflation is falling far short of the 2% target, and in the interest of preventing an excessive reaction by the financial markets, the BOJ was likely forced to offer such a strained description.
The BOJ noted that long-term interest rate yields “may move upward and downward to some extent mainly depending on developments in economic activity and price”, and decided to double the yield for ten-year government bonds from the current ±0.1% to ±0.2%, while still maintaining a “zero yield” target interest rate.
While the current measures may superficially be called additional monetary easing, in reality they strongly resemble the yield curve control (YCC) introduced in September 2016, which was the starting point of de-facto normalization.
After the YCC was rolled out, the BOJ began its de-facto normalization policy of “stealth tapering” for slowing the pace of its long-term government bond purchases, and this policy is still going strong. I believe these new measures to be part of this de-facto normalization, the aim being to lessen the side effects of quantitative easing—namely the low liquidity in the bond market and the decline in financial intermediary functions—by allowing for greater fluctuation and for a rise in long-term interest rates. The latter is especially important, and the BOJ could well be looking to improve the banking business environment through higher long-term interest rates.
In that sense, these new measures are like Phase Two of the de-facto normalization policy, or “Normalization 2.0”. And given that Phase One was stealth tapering, Phase Two could perhaps be termed “stealth interest rate-raising”.
YCC to Be Softened Further
As early as sometime this year and no later than the first half of next year, the BOJ could potentially take another measure to promote de-facto normalization by further raising long-term interest rates so as to improve revenues for financial institutions, even while maintaining its “zero yield” target for long-term interest rates.
Due to the BOJ’s decision to expand the range for long-term interest rates, the reliability and stability of the YCC have markedly declined from what they were. If there were some external shock—say, if the prevailing market view were that the range would be expanded again to allow long-term interest rates to rise even further, or if long-term yields were to rise overseas, then long-term rates could potentially begin testing the upper limits of their range, leaving the BOJ unable to maintain those upper limits.
When that happens, or perhaps in anticipation of it, the BOJ might modify the YCC into a looser mechanism by eliminating the interest rate range and implementing a limit price operation as a restraint for when interest yields rise significantly. At such time, even if the BOJ were to maintain its superficial explanation that its YCC framework with the zero target for ten-year bond yields was still in effect, in substantive terms the controls on long-term interest rates would disappear.
Official Implementation of Normalization Policy to Come After the Consumption Tax Hike?
However, I believe the BOJ will go further than simply having this de-facto normalization policy, and that it will eventually implement normalization officially by publicly affirming its policy as such. With the current decision, the BOJ also adopted forward guidance indicating its future policy interest rate direction, stating that the BOJ “intends to maintain the current extremely low levels of short- and long-term rates for an extended period of time, taking into account uncertainties regarding economic activity and prices including the effects of the consumption tax hike scheduled to take place in October 2019”. The reference made to the consumption tax is crucial, and this can be read as a declaration by the bank to the Japanese government—which is concerned about what effects the consumption tax hike may have on the economy—that it promises not to officially implement normalization by raising the policy interest rate target before the consumption tax increase, and also that if it can be verified that the effects of the consumption tax hike on the real economy are not significant, the bank will officially adopt a normalization policy for raising the short-term or long-term interest rate target in 2020, for example. Of course, by that time the bank could soften its 2% inflation target to a medium-term target to erase the difference between the stagnating inflation rate and its normalization policy.
Nomura Research Institute, Ltd.
Corporate Communications Department