Don’t mis­read the BoJ’s sig­nals

Financial Mirror (Cyprus) - - FRONT PAGE -

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.”

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