BoJ: That sinking feeling
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.