Thursday, February 9, 2023

The Bank of Japan’s policy predicament

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If Haruhiko Kuroda hoped to engineer a smooth handover to his successor as governor of the Bank of Japan then he has blown it already. Kuroda’s decision in December to relax, but not abandon, his policy of capping the yield on Japanese 10-year bonds at zero per cent has given markets what they love best: a vulnerable, official peg against which to speculate. This half-pregnant policy — reaffirmed at Wednesday’s meeting of the central bank’s policy board — will be a vexed legacy for whoever comes next.

The BoJ introduced yield curve control, as it is known, in September 2016. During the first half of Kuroda’s tenure, which began in 2013, the central bank bought massive amounts of government bonds in an effort to drive down long-term interest rates and kick-start the stagnant Japanese economy. Under YCC, the bank moved away from numerical targets for asset purchases, and promised instead to buy as many bonds as needed to keep 10-year yields close to zero. For several years, this policy was fairly successful. It kept rates low for borrowers, and because markets felt the cap on yields was credible, the BoJ did not have to buy many bonds to maintain it.

That changed last year, as rising interest rates in the US and elsewhere created a yield gap with Japan. Investors sold the yen for higher-yielding alternatives, resulting in heavy downward pressure on the Japanese currency; it weakened past 150 against the dollar at one point. With high commodity prices creating some inflation in Japan, the bond market began to malfunction. A kink formed in the yield curve at the 10-year mark controlled by the BoJ. Even then, faith in YCC was strong until Kuroda suddenly shook it with December’s unheralded decision to let yields rise, but only as high as 0.5 per cent.

That opened the floodgates. Now, passivity is no longer an option for the BoJ. It must either buy trillions of yen in bonds to defend its yield cap, or abandon YCC altogether. The central bank could also dilute YCC towards irrelevance by setting a cap so high as to be meaningless, or capping a short-term bond yield.

There are arguments in both directions. In support of keeping YCC is Japan’s economic situation. The BoJ still expects core inflation, which excludes fresh food prices, to come in below its inflation target in the years to March 2024 and 2025. Indeed, Japanese workers still struggle to get a pay rise. This is markedly different to the US and Europe, where rates are rising to head off the risk of a wage-price spiral, and inflation is well above target. It would be somewhat perverse for Japan to engineer a monetary tightening, which is what abandoning YCC would mean, as the world economy slows down. Sustainably reaching 2 per cent inflation has been Kuroda’s mission for a decade. It is finally in sight.

In support of scrapping YCC is the perilous position in which the BoJ now finds itself: in the crosshairs of every macro hedge fund looking to make its annual returns before the first quarter is out. If the BoJ tries to defend YCC and fails it will pay a bitter price in cash and credibility. Then, too, Japan’s policy mix did need some adjustment. The goal of monetary easing was to create a virtuous circle of rising demand, consumption, prices and wages. Creating demand via a weak yen, which hurts real incomes, is far from ideal.

The task for the new BoJ governor — or Kuroda in his last few months — is to restore some coherence. The objective must remain to hit the 2 per cent inflation target, now and for years to come. The challenge is to recalibrate YCC, or judge the timing of its abandonment, in a manner that is both credible to markets and consistent with that goal.



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