20 December 2018
The Bank of Japan is acutely aware of the side effects of its massive easing measures, but recent market volatility is making it increasingly difficult for it to fine-tune its policies in the near future. Under the current conditions, we see very limited scope for the BOJ to make any moves in the coming year, and the second half of 2019 would be particularly difficult given a planned consumption tax increase.
Sales tax increase on deck in 2019
The BOJ maintained its ultra-easy policy on Thursday as expected, keeping its short-term interest rate target at minus 0.1 per cent and pledging to guide 10-year Japanese government bond yields around zero percent. It reiterated that it intends to preserve the current ‘extremely low levels of short- and long-term interest rates for an extended period of time’.
Japan’s central bank faces the domestic challenges of stubborn downward pressure on prices and a shrinking Japanese government bond market, and external challenges posed by the prospect of stalling global growth. While other major central banks are already walking a tightening path - on Wednesday, the U.S. Federal Reserve increased interest rates for the fourth time this year, and the seventh time in three years - the BOJ is unlikely to follow suit any time soon. There are several reasons for this.
One reason is recently volatile markets. Beginning in October, investors’ fears about global growth and geopolitical uncertainties coincided with sharp falls in the oil prices, and this is taking a toll on equities markets and risk sentiment.
Japan is scheduled to raise its national consumption tax next October to 10 per cent from the current 8 per cent, a step aimed at addressing the country’s public debt burden. While the tax hike could be postponed for political reasons, I see a more than 50 per cent chance that it will proceed, making it unlikely that the BOJ’s risk assessment will change significantly until at least sometime in 2020, as it seeks to avoid adding to any possible fallout on consumption from the tax hike.
Shrinking liquidity, falling yields
The BOJ is increasingly worried about the side effects of its prolonged monetary easing, and its lack of any further easing tools to address future scenarios. The Financial System and Bank Examination Department’s stress tests on the financial system have shown steady deterioration, particularly for regional financial institutions. That said, this deterioration is not due only to the BOJ’s policies, but also to regional banks’ limited opportunities to transform their businesses amid the declining financing demands.
The functionality of the bond market is another side effect of the central bank’s massive easing. As the BOJ’s JGB holdings have grown, bond market participants have fewer notes to sell in the central bank’s bond-buying operations. As of 10 December, the BOJ held 471 trillion yen worth of JGBs on Dec. 10, amounting to nearly half the value of all those issued. Financial institutions’ JGB holdings have dropped, and they sold only 17.6 trillion yen in bonds to the central bank in its last month, down from about 25 trillion yen per month in the first half of 2018.
In late July, the BOJ stated it would carry out its massive JGB purchases in a more ‘flexible manner’, and would allow long-term interest rates to fluctuate depending on economic and market developments. It widened the allowable range for the 10-year yield under its yield curve control (YCC) policy through which the central bank has been guiding short-term interest rates since 2016, with the ceiling raised to 0.2 per cent from 0.1 per cent.
But facing upward pressure from rallying U.S. Treasuries in recent weeks, JGB prices have also risen, and the 10-year JGB yield has wallowed around 0.025 per cent. Some strategists say that the benchmark yield could possibly turn negative again, to the detriment of Japanese banks’ profit outlooks.
If market conditions are favourable - for instance, if the yen trades stably and does not appreciate, and if risk appetite returns and sentiment rebounds - the BOJ might make some policy adjustments ahead of the planned tax increase. But a drastic change, such as scrapping the YCC policy, is unlikely.
Inflation target is more elusive
The BOJ no longer has a firm timeline to meet its price target of 2 per cent inflation, which now seems more elusive. Data this week showed that Japan’s output gap in the third quarter turned negative for the first time in almost two years.
While BOJ board members will eventually discuss an exit to easy monetary policy, Governor Haruhiko Kuroda didn’t deliver or hint at any changes of his own views on the side effects, reinforcing the notion that an exit will likely not be on their agenda in the near term.
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