NN IP: Bank of Japan’s monetary policy is close to being maxed out

NN IP: Bank of Japan’s monetary policy is close to being maxed out

Japan Monetary policy
Japanse economie.jpg
  • Yield curve control has little room left; further reflation will depend on positive shocks
  • Government investment plan should support domestic demand, may boost wages
  • BoJ has held off on further easing to limit pressure on bank profits

The Bank of Japan has gone further into unconventional territory than any other central bank. It currently owns more than 40% of outstanding Japanese Government Bonds (JGBs) and actively controls the 0-to-10-year segment of the yield curve. All this has not been sufficient to anchor Japanese inflation expectations to the 2% inflation target, which the bank has been trying to do for more than 6 years. If the inflation outlook deteriorates the BoJ may twist and tweak its policy stance here and there, but the big picture is that its policy is close to being maxed out. Other positive demand shocks such as global growth or fiscal policy will be needed to complete the task of reflation.

The BoJ has not been able to fully reflate the economy

Since 2013 the BoJ has been experimenting with unconventional monetary policy. In the early days the emphasis was on the size of the balance sheet. Later it switched to trying to control the nominal yield across the curve, the idea being to push real yields below their unobservable equilibrium level in order to boost nominal growth. This should push real rates down further, providing additional impetus to the real economy.

With the 10-year yield target at 0% and the policy rate at -10 bps, little room is left for pushing nominal yields lower. The only thing BoJ Governor Haruhiko Kuroda can do is sit tight, that is, keep the yield curve where it is and hope for a positive demand shock to fuel the flames of reflation further.

One issue that has probably been very disappointing to the BoJ is that inflation expectations turned out to be much stickier than expected. There was some real progress here until the 2014 VAT hike, a fiscal policy mistake that reversed any progress made. No real recovery is in sight. Inflation expectations remain very adaptive, being driven by past inflation outcomes.

In much the same way as in the US and Europe, these actual inflation outcomes disappoint as well, possibly due to structural factors that monetary policy cannot solve. The Japanese labour share of GDP declined substantially after 2000 and has not recovered yet, despite a labour market that is red hot, judging by the job-to-applicants ratio, which is close to a 50-year high. Businesses remain extremely wary of raising output prices and core wages, and prefer to deal with labour market overheating by investing more heavily in labour-saving technology. The positive side of such investment during the past year of uncertainty is that it mitigated the slowdown in Japanese investment spending.

A horse race between domestic strength and external weakness

As far as the immediate cyclical outlook is concerned, this is best viewed as a race between domestic resilience and external weakness. External risks have already created some negative spill-over. Capex spending has cooled off, as has the rate of employment growth, to a lesser extent. The concomitant reduced pressure in the labour market has also led to somewhat slower nominal wage growth. Consumption in Q3 got a boost from the run-up to the VAT hike and is likely to be weak in Q4. The downside risks to the domestic demand outlook are further underlined by declines in various business surveys and consumer surveys over the past months.

 In response to this, Prime Minister Shinzo Abe’s administration is preparing a supplementary budget, which combined with the 2020 Tokyo Olympics should keep domestic demand afloat next year. This is not a certainty, though. The supplementary budget is likely to focus on public investment and it may be difficult to spend all that is planned due to a shortage of labour input, although this could very well push nominal wage growth higher, a necessary condition for further reflation.

BoJ so far has not followed up on its easing bias

Because of the prospect of more fiscal easing and the fact that the trade-weighted yen depreciated mildly while the stock markets rose since the summer, the BoJ decided not to follow up on its easing bias and remained on hold at its latest meeting. The bank is acutely aware that easier policy could further corrode the profitability of the banking system. One might even say it is trying to calibrate its policy stance so that it supports the real economy without increasing the burden on banks.

This is not an easy task. In the event of appreciation of the yen, a stock market decline or lower global growth, the BoJ would surely like to be able to push the policy rate lower. In this respect it has much more room than the European Central Bank. At the same time the BoJ has been struggling with its control over the 10-year yield, which fell below the lower boundary of the 20 bps range around the 0% target in late summer. To strengthen its control, the BoJ should arguably be prepared to sell JGBs whenever there is strong global downward pressure on safe Treasury yields, although this would run counter to its aim of expanding its balance sheet.

In addition to all this, the BoJ would like to steepen the curve beyond the 10-year segment to give life insurers and pension funds more breathing room, but it is not obvious how to do this. In an ideal world a cut in the policy rate would raise future nominal growth expectations and thus longer-term yields as well. In the real world, such a cut could cement the notion of “lower forever” more strongly, in which case long-term yields would fall. Keeping 10-year yields at zero on average by selling JGBs when necessary might help in this respect.

At its latest meeting, the BoJ changed the forward guidance to say: “The BOJ expects short- and long-term interest rates to remain at present or lower levels as long as needed to pay close attention to the possibility that the momentum toward achieving its price target will be lost.” If this guidance conveys anything, it is the feeling that monetary policy has indeed reached its limit. After all, if the BoJ were to follow the Fed rule book, the mere possibility that inflation momentum might be lost would be sufficient to impel the bank to do everything in its power to provide more easing.

It is entirely possible that the bank will tweak its yield curve control policy here and there so that it steepens the curve. If so, markets would probably take this positively for a while. Still, such tweaks will come only after events that will probably push markets lower first. But in the grand scheme of things the Japanese reflation process is surrounded by question marks; for these to disappear, the BoJ and the government may well have to go for the nuclear option of 'helicopter money'.