Bank of Japan defies expectations of second straight round of policy corrections

At the Monetary Policy Meeting held on January 17 and 18, the Bank of Japan (BOJ) decided to maintain the status quo for its monetary policies. At the previous meeting, the BOJ had relaxed its Yield Curve Control policy (YCC) to widen the variation range for long-term government bonds, making an abrupt policy correction allowing those bond yields to rise. Despite already mounting speculation in the financial market about additional measures, the BOJ declined to raise the cap on yields a second time, avoiding what would have been a second straight round of policy corrections. As the currency market had already factored in the possibility of such corrections, this move only caused the yen to depreciate even further.

In its Outlook Report, the BOJ’s price outlook for FY2024 was upwardly revised from +1.6% (last October) to +1.8%, which more closely approaches the BOJ’s price stability target of 2%.

Some in the financial market are speculating that after the new regime arrives in April, the BOJ will declare that its 2% price stability target is now realistically in sight, and will swiftly undertake the normalization of its monetary policy by eliminating negative interest rates, for instance. However, this anticipation likely goes too far. As the underlying reason behind why the FY2024 CPI inflation rate outlook was slightly higher than the +1.6% in FY2023, the BOJ cited a technical factor—namely, a reaction to the downward pressure being exerted on prices by the government’s economic policies.

The biggest issue for the BOJ at the moment is how to quickly recover from the circumstances that forced it to make massive purchases of government bonds. With market speculations about further widening of the bond yield range and other additional YCC adjustments driving long-term government bond yields higher, in order to keep the cap on this variation range, the BOJ was forced to make its largest-ever purchase of approximately 12 trillion yen in bonds in just four business days. This is not sustainable, and if these conditions persist, then additional YCC fixes potentially could be implemented at the next meeting in March.

Additional fixes in March will depend on market conditions

That said, this decision by the BOJ to hold off on making any policy changes has eased speculations in the financial market about any further revisions coming soon, and if the upward pressure on long-term government bond yields abates, the BOJ might well decide against enacting any more such changes at the next meeting in March.

It’s conceivable that additional corrections might not be readily accepted by Governor Kuroda. If substantial revisions are made to the YCC in a short period of time, it would create the impression—at the very end of his tenure—that the monetary easing framework had suddenly collapsed. Governor Kuroda seems to be strongly inclined to keep this framework in place for the duration of his term. Perhaps Governor Kuroda is not as seriously concerned as the BOJ’s administrative staff when it comes to the negative effects of things like the ballooning of the BOJ’s balance sheet from massive purchases of government bonds, or the impaired function of the JGB market.

In addition, with March being the end of the fiscal year, an increase in government bond yields would have an adverse effect on the financial statements of private banks, which is probably something that the BOJ would prefer to avoid if possible. If the JGB market manages to recover some stability, then at least any further revisions to the YCC would be the basis for the new regime coming in April—that’s the baseline scenario desired by the BOJ at this point.

Four possibilities for YCC revisions

There are four possible ways that YCC revisions could be enacted going forward. The first would be to widen the yield range to ±0.75%, or perhaps to ±1.0%. The second would be for the BOJ to revise its fixed-rate purchase operations and amend its policy stance of keeping the cap at all costs. The third would be to abolish the YCC variation range. The fourth would be to get rid of the YCC framework itself.

If we think about this in terms of the near future, the probabilities of these scenarios likely diminish sequentially from the first to the fourth. If the yield variation range were to be widened again, we could expect that it would be broadened from the current ±0.5% to ±0.75% or maybe ±1.0%. Even if this variation range were expanded to ±0.75%, there’s a risk that the ten-year government bond yield would stick to its cap, and that the same sort of situation would repeat itself, so given this risk, it’s conceivable that the variation range could also be raised not to ±0.75% but to a more drastic ±1.0%.

However, it’s possible that the equilibrium level for ten-year government bond yields could be lower than 1.0% and actually be around 0.8% instead, which means that raising the cap to 1.0% might be going too far. Moreover, with concerns over inflation now receding, there is growing speculation in the US that the Federal Reserve Board (FRB) will start slowing down the pace of its interest rate hikes, and speculations about rate drops could even begin to intensify eventually. In that event, it’s even conceivable that any further declines in US long-term government bond yields—which have a major influence on Japanese long-term government bond yields—could also put downward pressure on the ten-year bond yields in Japan.

In light of these points, it’s possible that even if the variation range isn’t suddenly widened to ±1.0%, the BOJ could start drawing down its purchases of government bonds. In any case, it will all depend on market conditions.

The second possibility, namely a revision to the management of fixed-rate purchase operations, surely is also worth considering. The BOJ has a clear goal in maintaining this yield control at a specified level, and that gives the market a ready target to focus on. If the BOJ stopped conducting fixed-rate purchase operations every business day at this yield cap and instead allowed yields to increase beyond the cap to some extent, the market—having lost its target—could perhaps regain some stability. In that event, the BOJ could probably draw down the amount of its government bond purchases.

However, after those fixed-rate purchase operations have been revised, the market will immediately move to seek out the BOJ’s new yield cap, and there’s a decent chance that yields could significantly increase until that speculative activity has abated. Revising fixed-rate purchase operations is perhaps somewhat too risky a strategy at this juncture.

Will the BOJ maintain YCC until negative rates are gone?

On the other hand, there’s the risk that even if the variation range is widened again, yields will immediately rise to the new cap and stick to that level, and thus there is some speculation that the BOJ may choose to abolish the YCC variation range (third possibility), or even get rid of the YCC altogether (fourth possibility).

Nevertheless, this fourth possibility that the BOJ will discard YCC all of a sudden wouldn’t appear to be very likely this year, even under the new regime in April. Now, YCC is a highly problematic policy framework that reduces the functionality of the government bond market, and that also constrains the BOJ from curbing its government bond purchases, and I myself believe that it would be desirable to do away with it as soon as possible.

However, for the BOJ, YCC seems to be more than simply one part of its monetary easing framework—it rather appears to be a necessary framework for the BOJ to smoothly ending the zero-interest rate policy, which would be the greatest culmination of the normalization policy that will be pursued under the new regime.

In order to ensure the stability of long-term government bond yields, the BOJ will need to employ a combination of two measures—namely, increasing or decreasing its government bond purchases, and forward guidance for controlling expectations in the financial market by signaling its plans for the future of policy interest rates. However, when it comes time for the BOJ to end negative interest rates, there’s a risk that if the financial market expects policy interest rates to be raised significantly going forward, then long-term government bond yields could jump substantially. It’s not certain whether forward guidance along will be enough to maintain the stability of long-term government bond yields.

The BOJ likely believes that for it to smoothly bring negative interest rates to an end, it will have to retain this framework of purchasing government bonds under YCC, flexibly buying these bonds as needed through fixed-rate purchase operations and such in order to curb the rise of long-term government bond yields.

If it gets rid of YCC and ceases to control long-term government bond yields, it will lose its reason for conducting these fixed-rate purchase operations at a specified level. Further, even if only the YCC variation range were abolished, if the BOJ were to conduct fixed-rate purchase operations at a specified level when it eliminates negative interest rates, a new cap would effectively be established at such time.

Given the foregoing, we should suppose that until the BOJ is ready to end negative interest rates (which will be the pinnacle of its normalization), it will not go through with abolishing the YCC variation range or getting rid of YCC altogether, but instead will preserve the YCC framework.

Amending the “accord” between the government and the BOJ, under government leadership

We should look most carefully for the BOJ’s next actions to occur on April 27 and 28, which is when the first meeting under the new Governor will be held. It’s possible that the BOJ will bring a greater degree of freedom to its monetary policies by reframing its 2% price stability target as a long-term objective, for instance, or alternatively, that it will even move to overhaul the 2013 accord between the government and the BOJ, including a reprioritization of that 2% target.

The BOJ probably wants to revise the priority of the 2% price stability target independently. That’s because if it were to do so by amending the accord in coordination with the government, the BOJ would have to work closely with the government before making any policy (strategy) revisions, which would ultimately set another bad precedent.

The BOJ’s interpretation might be that by returning to the original concept of the accord, it can independently alter the priority of the 2% price stability target without having to amend the accord itself.

However, the Kuroda Administration seems inclined to make revisions to BOJ policy under government leadership, and would appear to be insistent about making changes to the accord between the government and the BOJ. It’s conceivable that the BOJ will ultimately be made to accept this outcome.

Conversely, a revision to the 2% price stability target or a major shift in monetary easing would be seen to undermine the legacy of Abenomics, and as such it could be expected to face stiff opposition from the conservative wing of the LDP. As a result, reworking the accord would be a heavily politicized act, and the actual content of the revision could also perhaps be difficult for the government to adjust. The BOJ might inadvertently end up embroiled in that political struggle.

Will there be a major policy transition in April?

On the other hand, the possibility that the BOJ could decide at the April meeting to end negative interest rates and abruptly shift towards normalizing its monetary policies—while a low one—cannot be completely denied. A major policy correction at the time of a change in Governor would be quite natural. In fact, in April 2013, under the newly appointed Governor Kuroda, the BOJ made a significant “surprise” policy shift at its very first meeting, rolling out a “quantitative and qualitative monetary easing” program.

However, we probably can’t put this case from ten years ago when those new easing measures were adopted and the revision and normalization of an unprecedented, decade-long easing into the same category. If the BOJ is to enhance its monetary easing, there’s no need to strongly caution against a bad reaction in the financial market, but if it seeks to make an easing correction, it will be impossible to avoid a bad response in the financial market or a market rewind, such as appreciation of the yen, a rise in long-term government bond yields, and/or falling stock prices.

If a hasty policy shift were to produce confusion in the financial market like the sudden appreciation of the yen, the BOJ (under the new regime) would likely face harsh criticism from the people again. For that reason, the BOJ might be hoping to avoid making any such abrupt shifts in policy.

Will the end of negative interest rates and other normalization measures come starting in mid-2024?

Thus, in light of the BOJ’s traditional stance of giving full consideration to financial market stability, there’s probably little chance that the BOJ will declare that reaching its 2% price stability target is now realistically in sight and will go so far as to end negative interest rates in a single stroke this April. While announcing a shift in its policy stance toward normalization, before it ends negative interest rates (a correction of a specific policy measure), it will likely take its time to factor that possibility into the financial market.

Plus, in terms of ensuring a degree of freedom in the conduct of monetary policies going forward, it might be more likely that the BOJ will first try to clearly reassess the priority of its 2% price stability target, the feasibility of which is low, and then work towards normalization. This is because if it maintains its 2% price stability target as-is, there’s a risk that the BOJ’s monetary policies could remain bound by that target in the future as well.

Yet we should recognize that while the BOJ is taking this time to stay in dialogue with the market, domestic and global economic conditions will grow more severe, the yen will continue to appreciate in the currency market, and speculation over FRB easing policies will only intensify. In that case, we can anticipate that the BOJ will hold off on enacting normalization measures or policy corrections like ending negative interest rates, which could lead to rapid appreciation of the yen or other chaos in the financial market, and that it will wait instead until mid-2024 or beyond to do so.

We should rather suppose that if any policy (strategy) corrections have a reasonable chance of happening this year, they’d only be additional revisions to YCC, such as another widening of the yield variation range, or a reprioritization of the 2% price stability target.

• Takahide Kiuchi

  Executive Economist