On July 28, the Bank of Japan (BOJ) stated at its most recent monetary policy meeting that it would flexibly control the yield on ten-year government bonds. On one hand, it decided to maintain the target range for ten-year Japanese bond yields at ±0.5%. On the other hand, the central bank will continue to purchase ten-year government bonds at a yield of 1% on each business day, not the previous 0.5%.
Significantly, the BOJ for the first time mentioned "flexibly managing the yield curve," possibly indicating the initial step towards a policy shift.
Markets Left Puzzled: What is the BOJ Trying to Accomplish with the Shift from 0.5% to 1%?
According to Marc Cudmore, an analyst at Bloomberg, the BOJ raised the fixed rate for purchasing Japanese government bonds to 1% and will carry out flexible market operations to maintain YCC. This means that the BOJ can now tolerate a rise in the yield of ten-year government bonds to 1%.
In essence, the BOJ is cautious about the market volatility that a direct "strike" would cause and doesn't dare to adjust the YCC directly. Hence, it has done a "half-hearted" job, quietly "testing the waters" to maintain operational flexibility, and to intervene promptly during bond market turbulence.
However, the BOJ's covert actions have caused ripples worldwide. The US dollar soared against the yen, the yield on ten-year Japanese government bonds rose to 0.550% (a high since September 2014), Japanese stocks plummeted, and the European market experienced a joint stock and bond plunge.
Some analysts have criticized the BOJ's actions, arguing that when central banks fail to show 'Bazooka'-like resolution in executing monetary policies, the results are always disastrous. They claim that the BOJ's recent behavior is no exception, as it only complicates matters.
Has the BOJ Lost Market Trust?
The BOJ introduced the YCC policy in 2016, lowering the yield on ten-year Japanese bonds through infinite bond purchases. In December of the previous year, the BOJ unexpectedly announced an increase in the YCC limit, leading investors worldwide to bet that the BOJ would further loosen control this year.
However, the BOJ's unexpected adjustment to the fixed rate for purchasing Japanese government bonds reignited discussions about its monetary policy returning to normalization.
According to the BOJ's statement in the interest rate decision, the central bank will continue to purchase Japanese bonds on a large scale and respond flexibly to each term, such as increasing the quantity of Japanese government bonds to be purchased and conducting Fixed-rate Funds-Supplying Operations against Pooled Collateral.
The BOJ also stated that it would purchase ten-year Japanese bonds at an interest rate of 1.0% in fixed-rate operations, not the previous 0.5%.
What's the Future of BOJ's Monetary Policy?
Nobuyasu Atago, a former BOJ official and chief economist at Ichiyoshi Securities, stated that the BOJ, by raising the fixed rate to 1.0% instead of directly adjusting YCC, aims not to give the market an expectation of policy normalization. But this move makes it harder for the market to judge future tightening measures by the BOJ.
Even though the BOJ's decision isn't as hawkish as directly loosening the YCC range, and the essence of the loose policy hasn't changed, market participants seem to assume that the new YCC ceiling has become 1%. This level implies that the fluctuation range of Japanese government bonds has doubled, causing the yield on ten-year Japanese government bonds to hit a high of 0.575% in afternoon trading in Japan.
Most importantly, communication between the BOJ and the market may become more challenging in the coming months. A sudden shift by the traditionally dovish Kazuo Ueda may affect his credibility.
According to Bloomberg's latest survey, only 18% of economists believe that the BOJ will adjust or cancel the yield curve control (YCC) policy this week, 82% of economists expect no policy changes in this meeting, and 40% expect no adjustments within the year. The survey also shows that about 60% of the market would be surprised if the BOJ took action this week.
What's Next for Japan's Inflation?
The key to whether the BOJ adjusts monetary policy is inflation. If the BOJ can achieve its inflation target in the future, it will start the normalization of monetary policy.
From a data perspective, Japan's inflation is significantly higher than 2%. Overall inflation rose to 3.3% in June, surpassing the US for the first time in eight years. Core inflation "soared" to a high level of 4.2% not seen since September 1981. Core consumer inflation has been above the BOJ's 2% target for 14 consecutive months, meeting the conditions for modifying YCC.
Moreover, due to the rebound in inflation, which has led to an increase in bond yields, the BOJ is finding it increasingly challenging to suppress market interest rates through YCC.
The latest data shows that Japan's CPI growth in July exceeded expectations, once again highlighting the severe inflation pressure in Japan. For this reason, the BOJ adjusted its inflation forecast for 2023 at this meeting.
The BOJ revised its inflation outlook for the 2023 fiscal year from the previous 1.8% to 2.5%, which is higher than the 2% target. However, the BOJ lowered its core CPI forecast for the 2024 fiscal year from 2.0% to 1.9% and forecasted that by the 2025 fiscal year, the core CPI would fall to 1.6%. This means that the BOJ's long-term inflation outlook remains below 2%.
Kazuo Ueda indicates that there have been some signs of changes in corporate pricing behavior, but at the same time, he states that inflation stabilization and wage growth have not been seen yet. There is still a distance to achieve the 2% inflation target, and the uncertainty of the economy and prices is very high.
Kazuo Ueda believes: "We have not yet achieved a 2% inflation trend. We have a long way to go to raise the short-term interest rate target."
As previously analyzed by Wall Street Journal, the Bank of Japan has its own concerns when facing this inflation shock. Mainly because the source of this inflation is not what the Bank of Japan wants to see: Japan wants inflation driven by domestic demand, not externally imported inflation.
Although current Japanese inflation is composed of both domestic demand and external inputs. However, as Japan's trade deficit has not improved for 22 consecutive months, what the Bank of Japan does not want to see is the appreciation of the yen after policy tightening, which is very likely to further worsen the current trade deficit situation.
But as the market bets that the interest rate hike cycle of the US and European central banks is coming to an end, it has somewhat relieved the interest rate pressure of the Bank of Japan, and the US dollar index continues to weaken, and the corresponding yen has appreciated, providing a time window for the Bank of Japan.
The reason why the Bank of Japan is so hesitant to exit YCC may also be related to the early exit in previous years, leading to a drop in inflation again. Former Federal Reserve Chairman Bernanke has analyzed the major policy mistakes of the Bank of Japan:
From 1987-1989, despite evidence of increasing inflationary pressures, the policy was not tightened, which led to the formation of the "bubble economy".
From 1989-1991, the stock market bubble was intentionally burst, leading to a crash in asset prices.
From 1991-1994, in the face of falling asset prices, bank risk exposure and economic downturn, policy was not sufficiently relaxed.
Is this the first step towards normalization for the Bank of Japan? Kazuhito Menjo, the former chief economist of the Bank of Japan, believes that the hidden motive of the Bank of Japan's adjustment today is the yen exchange rate. Because before the monetary policy meeting, the yen weakened and there was a risk of further depreciation. The Bank of Japan decided not to directly purchase yen, but to influence the yen exchange rate by affecting the bond market:
Properly relaxing yield curve control can reduce the pressure on yen depreciation. This is not the first step in monetary policy normalization. I describe it as a fine-tuning, not an adjustment or turnaround.
Kazuhito Menjo believes that now is not the time when the Bank of Japan least wants to send such a signal to the market - this is the first step in policy normalization, so Kazuo Ueda will repeatedly emphasize that if the YCC policy is exited, more explicit policy guidance will be given.
As Kazuhito Menjo said, Kazuo Ueda emphasized after the policy meeting that today's measures do not represent a step towards monetary policy normalization, but the market believes that the Bank of Japan has loosened its control over the yield target range, which is the first step in normalization.
The yen once plummeted, then rose again, erasing all the declines since the Bank of Japan's interest rate decision. The increase continued to expand, once breaking through the 139 mark, now reporting 139.49.
The yield on 10-year Japanese government bonds soared 11 basis points to 0.557% in the afternoon, refreshing a nine-year high.
The Nikkei 225 Index fell as much as 2.4% before narrowing its losses to close down 0.40%.
The Bank of Japan's surprise move also spread to global markets, with European stocks opening lower collectively. The German DAX index fell 0.27%, the British FTSE 100 index fell 0.07%, the French CAC40 index fell 0.06%, and the European Stoxx 50 index fell 0.29%.
