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I know what you did last summer

19 Sep 2016 By Quentin Webb

Bond scarcity and bank pain will inform the Bank of Japan’s next move in its battle to revive inflation. While a hot and humid Tokyo emptied out for the summer, BOJ technocrats spent the last few weeks slaving over an in-depth policy review. This will form the crux of the central bank’s board meeting on Sept. 20 to 21.

The results of this “comprehensive assessment” matter because BOJ Governor Haruhiko Kuroda has pioneered the use of bold tools to fight deflation and stoke growth in what remains, despite years of stagnation, the world’s third-largest economy. Huge bond-buying has swelled the central bank’s balance sheet above 450 trillion yen ($4.4 trillion) – equivalent to nearly a full year of Japanese GDP. The BOJ also spends 6 trillion yen a year on stocks – it already owns 3 percent of the Japanese equity market. This year it also introduced negative interest rates.

Partly due to these policies, Japan now enjoys effectively full employment, wages are rising, and prices are no longer falling. But the bank’s main goal of 2 percent annual inflation, coupled with self-reinforcing expectations of future price rises, remains elusive. The malaise contrasts with the United States. There, a stronger recovery means the Federal Reserve could soon raise rates for the second time in a year, moving monetary policy a bit closer to normal levels.

The Tokyo gathering will not force a drastic rethink. One ex-policymaker recently suggested the BOJ focus first on an easier goal of 1 percent inflation. But that is off-limits: Kuroda and Deputy Governor Hiroshi Nasako both stressed in recent speeches that the 2 percent target is here to stay. The time frame may be changing, however: after missing a 2-year deadline repeatedly, both BOJ leaders simply stressed a desire to hit the goal as soon as possible.

More broadly, the overall three-pronged strategy of quantity (massive bond buying), quality (buying equity funds) and negative interest rates also looks secure: the central bank thinks this has made a big contribution to Japan’s economic turnaround under Prime Minister Shinzo Abe.

Ample space

Nonetheless, the BOJ cannot keep buying 80 trillion yen ($775 billion) a year of government bonds indefinitely. It already owns about 40 percent of the market, according to Deutsche Bank. That has smothered liquidity and it could soon start running short of supply. But nor does the BOJ want spark a destabilising spike in bond yields by suggesting it will soon start to “taper” bond-buying.

One suggestion is that it ease away from its specific target of expanding Japan’s “monetary base” by introducing a wider range – perhaps 70 to 90 trillion yen. It might also buy some time by adding different securities to its basket, such as Fiscal Investment and Loan Program (FILP) bonds, a form of off-balance sheet government debt.

The risk of the current policy running out of steam is one reason Reuters says the BOJ is now leaning towards emphasising negative interest rates. That may seem odd because its decision in January to introduce a 0.1 percent negative rate on a sliver of deposits that lenders keep with the central bank has proved controversial and in some ways counterproductive.

In his Sept. 5 speech, however, Kuroda insisted there was “still ample space for further cuts in the negative interest rate.” The bank thinks negative rates have made borrowing cheaper and spurred lending, though Kuroda now acknowledges that the policy hurts bank profitability and plays havoc with insurers and pension funds. Japan’s financial watchdog reportedly thinks negative rates could lop 300 billion yen off profits at Japan’s three “megabanks” this year.

So any descent further into negativity might have to be balanced with concessions to the financial industry. One option is to scale back buying of long-term bonds, thereby allowing yields to rise. This would enable banks to exploit the difference between short- and long-term borrowing costs, improving their profitability. In recent weeks the yield curve has already steepened somewhat, perhaps anticipating such a move. Other targeted measures could include offering banks more funding for lending.

Timing matters, too. The BOJ can’t ignore external market ructions – including those created by its policies. The shock of negative rates, for example, unhelpfully whacked stocks and ended up strengthening the yen.

That’s why Kuroda and his colleagues must keep an eye on the Fed, whose meeting concludes just after the BOJ’s. A U.S. rate rise would lift the dollar and weaken the yen, aiding Japan’s exporters and importing inflation. But a dovish Fed could cause unwelcome yen strength. So the BOJ might prefer to lay out its the findings and wait until October, when it will have a clearer idea of what’s going on elsewhere, before acting.

Kuroda insists that “new ideas should not be off the table”, and that there is no limit to monetary policy, only different trade-offs between costs and benefits. But then he also believes that explicitly printing money to finance spending – so-called “helicopter money” – cannot be done in Japan. In reality, it seems like there is not much else left in the BOJ toolkit.


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