BoJ: That sink­ing feel­ing

Financial Mirror (Cyprus) - - FRONT PAGE - Joyce Poon and Tom Hol­land

You al­most have to feel sorry for poor Haruhiko Kuroda. Just over a week af­ter the Bank of Ja­pan gov­er­nor an­nounced his in­ten­tion to over­shoot the cen­tral bank’s 2% in­fla­tion tar­get, it is painfully ob­vi­ous that in­vestors be­lieve he will fall short. That much is clear from the Ja­panese govern­ment bond mar­ket. At last week’s meet­ing the BoJ an­nounced that from now on it will tai­lor its JGB pur­chases to tar­get a 10year yield of zero. In the days since, the 10-year has con­sis­tently un­der­shot that tar­get, trad­ing at -0.085% on Fri­day morn­ing—a fail­ure which raises the pos­si­bil­ity that to hit its yield curve tar­get, the BoJ could be forced to tighten mon­e­tary con­di­tions even as in­fla­tion ex­pec­ta­tions di­min­ish.

It is not just bond in­vestors who have zero faith in the BoJ’s abil­ity to goose up in­fla­tion. Data re­leased on Fri­day showed that Ja­panese house­hold spend­ing slumped -4.6% year-on-year in Au­gust, down from -0.5% in July in a fig­ure that was con­sid­er­ably worse than ex­pec­ta­tions. To be fair, Au­gust’s num­ber may have been de­pressed by the se­ries of trop­i­cal storms that hit Ja­pan over the month. But even so, over the last year and a half since the ef­fect of 2014’s sales tax hike fell out of the YoY data, the trend in house­hold spend­ing has clearly been down­wards. This is hardly the sign of a con­sumer base that be­lieves prices may rise any time soon. And it has lit­tle rea­son to: head­line con­sumer in­fla­tion fell - 0.5% YoY in Au­gust, down from -0.4% in July. Ex-food and en­ergy, “hard­core” in­fla­tion was still in pos­i­tive ter­ri­tory at 0.2%. But the trend is down: Septem­ber’s hard­core num­ber for Tokyo came in at -0.1%.

The de­cline in in­fla­tion ex­pec­ta­tions ev­i­dent from both the bond mar­ket and con­sumer sur­veys (see chart be­low) puts the BoJ in a quandary. Its ob­jec­tive in an­nounc­ing quan­ti­ta­tive eas­ing “with yield curve con­trol” was to re­lieve some of the pain in­flicted on the fi­nan­cial sec­tor by QE and neg­a­tive short rates. The hope was that with the 10-year yield an­chored at zero, bank­ing prof­its would be less crushed and banks more ready to lend.

How­ever, with in­fla­tion ex­pec­ta­tions de­clin­ing and the mar­ket pric­ing the 10-year yield be­low zero, the BoJ now faces the prospect that if it is to hit its yield curve tar­get, it will have to ta­per its 10-year pur­chases, or even be­gin to sell 10-year JGBs. This would un­der­mine the cen­tral bank’s ef­forts to con­tinue expanding the mon­e­tary base by JPY 80trn a year, and ex­pose the fun­da­men­tal con­tra­dic­tion of at­tempt­ing si­mul­ta­ne­ously to tar­get both the quan­tity and price of money. Of course, the cen­tral bank could try to off­set the im­pact of ta­per­ing its pur­chases at the long end of the curve by step­ping up its buy­ing at shorter tenors. But churn­ing at the short end of the curve will do even less to boost in­fla­tion ex­pec­ta­tions in the real econ­omy.

This high­lights the fa­tal weak­ness of the BoJ’s at­tempt at yield curve man­age­ment. By tar­get­ing the nom­i­nal 10-year yield, Kuroda hoped that as in­fla­tion ex­pec­ta­tions picked up, the real yield would fall, and that his pol­icy would thus prove highly pro-cycli­cal at boost­ing in­fla­tion. But what is pro­cycli­cal on the up­side is also pro-cycli­cal on the down­side. A de­cline in in­fla­tion ex­pec­ta­tions leads to a rise in real yields. That amounts to an ef­fec­tive tight­en­ing of mon­e­tary con­di­tions. More­over, higher real yields fa­vor a stronger yen, which in turn would ex­ac­er­bate de­fla­tion­ary pres­sure.

Faced with such a prospect, Kuroda’s “main pol­icy tool will be fur­ther cuts in the neg­a­tive short term pol­icy in­ter­est rate and low­er­ing the tar­get level of the long term in­ter­est rate,” as the cen­tral bank gov­er­nor ex­plained ear­lier this week. In other words, Kuroda is guar­an­tee­ing in­vestors a free put op­tion on the JGB mar­ket. If in­fla­tion ex­pec­ta­tions rise, he will cap 10-year yields at zero. And if they fall, he will shift the yield cap down­wards. As a re­sult, it is no sur­prise that yields have con­sis­tently fallen short of the BoJ’s zero tar­get rate since it was in­tro­duced last week.

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