Don’t misread the BoJ’s signals

The monetary policy committees of both the Federal Reserve and the Bank of Japan meet on Wednesday. But whereas the Fed faces a simple binary call—either raise rates or don’t—the decision confronting the Bank of Japan is more complex, and the market’s understanding of the dynamics at work hazier. With Japan back in deflation almost four years after the BoJ started the current round of quantitative easing and eight months after it pushed short term interest rates into negative territory, the central bank has promised a “comprehensive assessment” of its policy settings—a pledge that has persuaded some investors that BoJ governor Haruhiko Kuroda is getting ready to back away from a policy that has demonstrably failed.

They are misreading the signals. True, central bank officials including Kuroda have recently dwelt on the costs negative rates and QE impose on the financial system. Equally true, Japan’s yield curve has steepened significantly over the last eight weeks. But neither development is an indication that the BoJ is moving towards “tapering” its policy. Quite the opposite. The purpose of the comprehensive assessment is not to prepare for a reversal of course, but rather to find a way to alleviate the pain that negative rates and QE inflict on the financial system in order to allow the BoJ to step up its unconventional easing even further.

Unlike investors, BoJ officials (and their opposite numbers at the cabinet office) reject the idea that negative rates and QE have failed. They argue that over the past four years of QE the yen has depreciated more than -20%, corporate profits have picked up, Japan’s output gap has closed, unemployment has fallen, wages have risen and the stock market is up 80%. If this improvement in conditions hasn’t shown up in the inflation data, it is because of the slump in oil prices, the slowdown in global demand, and the negative impact of international financial market volatility on consumer sentiment. In other words, Kuroda and his colleagues believe their policy is gaining traction; it just needs more time.

However, the BoJ cannot continue its easing program in its current form indefinitely. Firstly, central bank purchases of JPY 10trn a month are severely squeezing the Japanese government bond market. At the current rate, the BoJ will have exhausted the available free-float within three years. Secondly, the combination of negative rates and yield curve flattening from QE compresses bank net interest margins. If extended, at some point the current policy will erode banks’ profitability to the extent it will reduce their ability to make new loans, at which point the costs of the BoJ’s policy will begin to exceed its benefits.

So if the central bank is to continue unconventional easing, it must find a way to take the pressure off the financial system. Its answer is to shift the pattern of asset purchases. The BoJ could buy more corporate bonds, more ETFs and more REITS—and all those options will be on the table tomorrow. However, the scale of any possible increase will be small relative to existing JGB purchases. As a result, it appears the preferred option is a coordinated move, in which the Ministry of Finance steps up its issuance at the long end of the curve, while the BoJ shifts its purchases more towards shorter-dated JGBs. The increase in long-dated issuance is already apparent, and anecdotally the emphasis of BoJ buying has lately moved down the curve.

The hope seems to be that the resulting steepening of the yield curve will support the financial system sufficiently to allow the BoJ to continue its easing program, and potentially to push short term interest rates deeper into negative territory at a future meeting in a further attempt to conjure up expectations of higher inflation. Whether any such attempt would be successful is doubtful. Despite all the central bank’s efforts to date, inflation expectations have remained stubbornly depressed. One thing is clear, however: at tomorrow’s meeting—as BoJ deputy governor Hiroshi Nakaso said earlier this month—“reducing the level of monetary policy accommodation will not be on the agenda.”