In last week’s post we outlined why the BoJ was the world’s most important central bank – in fact we used this very phrase as the title. As this latest policy statement shows we were not engaging in hyperbole. The BoJ has just announced a very significant policy change. Amazingly, many financial market participants have failed to comprehend this as evidenced by the sceptical post-announcement commentary and the swift reversal of the knee-jerk sell-off in the JPY.
Although the BoJ increased its equity and REIT-linked ETF purchase programme to just over JPY6.0tr per annum (more stimulus) the stand out change is the shift away from targeting the monetary base to targeting the Japanese government yield curve[1]. This is unquestionably a major break both from conventional monetary policy tools (the sole use of short-term interest rate targets) but also unconventional monetary policy tools adopted since the Great Recession (QE programmes).
While the former is self-explanatory (at least we hope it is), the latter may be less so, particularly as in their lengthy accompanying statement[2] the BoJ said that its purchases of JGBs will be “more or less in line with the current pace”, of JPY 80tr per annum. In no way should this be considered a target as it was under the old QQE programme, rather it should be viewed as, at best, a guess, at worst, a hope.
The reality is that once a central bank adopts a long-term interest rate target its balance sheet shifts from being exogenously determined (ie under the control of the central bank) to endogenously determined. This is because even an institution as powerful and far-reaching as a central bank cannot set both the price and quantity of an asset (Japanese government bonds in this case). If its commitment to target the 10-year JGB yield is to be maintained, it must necessarily lose control of its balance sheet[3] as it has no way of determining what excess market demand or supply of JGBs there will be at the target rate as this depends upon the preferences of the private sector over which it has no direct control (influence perhaps, but not direct control)[4],[5].
The amount of JGBs the BoJ finds itself having to purchase to ensure its yield target is achieved could, over time, be potentially significant given they also shifted their monetary policy goal – namely the CPI inflation target – up from 2% to “exceeding 2%… in a stable manner”[6].
Having a zero yielding 10-year nominal government bond when CPI inflation is running consistently above 2% is clearly a loser of an investment. Hence, the return-sensitive private sector would seek to offload their existing holdings of JGBs to the return-insensitive BoJ. That is unless, of course, investors either have an extremely bearish prognosis for the Japanese potential growth rate (i.e it is below -2%) or there are doubts about the credibility of the BoJ’s latest reflationary promise.
Of the two, there is certainly plenty of evidence of the latter amongst investors and the broader public as evidenced by the still modest sentiment readings for Japanese future inflation (see exhibit below). Indeed, this lack of belief in Japanese reflation may well be the reason why investors are blind (or asleep) to the significance of the policy regime change – for that is what it is – just announced by the BoJ.
Exhibit 1. Inflation Outlook Sentiment – Japan
Source: www.amareos.com
As further (more anecdotal) evidence of this scepticism we came across the following comment made after the BoJ announcement (we paraphrase): “promising to deliver CPI inflation above 2% is a bit rich given that, even under expansionist Kuroda[7], it has failed to sustainably deliver 2%”. In addition, some commentators have concluded that the shift to yield curve targeting by the BoJ is not so much a sign of strength but an acknowledgement of the limited options available to them to inject additional monetary stimulus (that impotence theme again).
These concerns are understandable and also have some legitimacy. Even the BoJ acknowledges that pace of the economy recovery remains “slow” and private-sector inflation expectations too weak. However, to conclude that this latest action means that Japan is doomed to perpetual price stagnation/deflation misses a crucial point.
On balance, we tend to agree that in, and of, itself the latest BoJ action will not generate the hoped-for reflationary impulse. Given the ingrained nature of the deflationary mindset in Japan[8]“jawboning” (a colloquialism for forward rate guidance) is hardly likely to be effective. Moreover, setting a nominal 10-year JGB yield target at zero when the yield was previously negative hardly constitutes monetary easing; if anything it is monetary tightening.
Nevertheless, the significance of the BoJ announcement is that they have made a change that is (always was in our opinion) a necessary prerequisite for the successful reflation of Japan’s moribund economy. It is a policy-making stepping stone, but a very important stepping stone.
As we made very clear in the previous post (and numerous others before) Japan’s fiscal position is dire; government debt is on an unsustainable trajectory and given the current level is nigh impossible to rectify via fiscal consolidation. Correcting this problem is not just an economic imperative but it has become a political imperative as well, as evidenced by the emergence of Abenomics. Japan needs sustained positive inflation- it really is that simple. It is just achieving this objective has been much more challenging than widely expected.
If the BoJ are unable to generate sustained positive inflation by calibrating monetary policy at super accommodative levels, then it will require the intervention of the fiscal authority, namely the Japanese government. The BoJ even hinted as much in their statement when they referred to “synergy effects” between monetary and fiscal policy.
Such thinking is hardly new or cutting edge. Indeed, as Tily (2012)[9] points out Keynes concluded as much in The General Theory of Employment, Interest and Money, published in 1936. To wit,
“Keynes’s support for fiscal policy did not follow primarily from any lower bound to this process but from recognition that a low long-term rate of interest might not be sufficient for recovery. A low long-term rate of interest was necessary to prevent recession, but it might not be sufficient to effect recovery from recession.”
By agreeing to backstop the JGB market, the BoJ is, in effect, facilitating the Abe government’s ability to engage in reflationary fiscal stimulus by loosening its constraints. After all, with the BoJ guaranteeing the price of government bonds, the threat of increased bond issuance triggering a JGB “death-spiral” is completely eradicated[10]. It also removes the more realistic threat that a back-up in interest rates chokes off the recovery as and when it materializes[11].
To those still sceptical about such a reflationary outcome, it is worth noting that a yield target not only facilitates, but is a pre-condition, for outright monetary financing[12] (OMF – or helicopter money in the vernacular); a policy that is very effective because the government can just keep issuing bonds – at a price now guaranteed by the BoJ – to satisfy the demands of any stimulus programme[13].
It is for these reasons that the BoJ’s adoption of a yield target is so significant[14].
For the avoidance of doubt, as intimated above, we do not envisage a smooth path towards this reflationary outcome. Most likely the Japanese policymakers will want time to assess the impact of the latest BoJ measures. Moreover, as we alluded to above, if – as we suspect – the latest measures are found wanting, the BoJ will be pressed into doing even more easing (Governor Kuroda promised as much in the press conference). But, there is a limit as to how far nominal interest rates can be pushed below zero: short-term interest rates because of the cash-arbitrage and long-term interest rates because of the implied loss on BoJ holdings[15].
So, if, as Keynes worried about all those years ago, a low yield (even zero) proves insufficient to generate a reflationary recovery given the economic and political need for higher inflation in Japan pressure on the government to inject fiscal stimulus (OMF in extremis) will rise inexorably[16], especially now the BoJ have put a floor under government bond prices.
In terms of the financial market implications, as we stated last week, Abenomics-On-Steroids would have an extremely bullish effect on Japanese equity markets – in fact on any nominally priced asset for its perceived inflation protection. It would also put the JPY under considerable pressure to depreciate (arguably the most reflating element of the first wave of Abenomics) particularly as a central bank locked-down zero yielding JGB provides a strong incentive for Japanese institutional investors to go offshore in search of higher returns[17].
It is patently obvious from the current level of crowd sentiment towards Japanese stocks and the JPY that this reflation theme does not yet feature on the radars of most investors. This suggests that once investors look beyond the lack of immediate monetary stimulus, and begin to comprehend more fully the longer-term ramifications of the BoJ announcement, there is potential for a very significant price move in both (unlike nominal JGBs).
Exhibit 2. Nikkei & JPY Sentiment
Source: www.amareos.com
Regards the global implications that flow from this decision. As we have previously stated the BoJ is a monetary policy vanguard; it has had to be because of circumstance. This remains the case. With global debt levels now higher than they were at the onset of the Great Recession, Japan may be the first country to have entered the era of fiscal dominance[18] (possibly by some margin) but it won’t be the last; currency markets will see to that.
Sentiment Analytics are based on MarketPsych indices.
[1] A further stimulative effect of this policy is via its impact upon the commercial banking sector as a steeper yield curve generates an earnings boost; something that definitely contributed to the rally in banking sector stocks immediately following the decision. However, as we will explain in the remainder of the note, compared to the broader implications of this policy change this is not a great deal.
[2] See: https://www.boj.or.jp/en/announcements/release_2016/k160921a.pdf
[3] This is the reason why the BoJ announced it had abandoned its target for expanding the monetary base – it had to.
[4] This was a longstanding concern of former Fed Governor Bernanke and it was one of the reasons why there was reluctance on his part to adopt this unorthodox policy measure during the Great Recession.
[5] The abolition of the average maturity guideline for BoJ purchases of JGBs will help them to fine-tune their operations.
[6] We have seen some suggestions that setting a yield target opens the door for the BoJ to begin tapering its purchases amid concerns about the sustainability of large-scale JGB purchases. We agree, for the reasons just mentioned, that the BoJ may well undershoot its JPY 80tr pledge but this would be by accident definitely not by design. Such tapering talk is, frankly, astounding as it reveals a complete misunderstanding of what the BoJ is aiming to achieve. Furthermore, of course, BoJ purchases of government bonds is hindering the functioning/liquidity of the secondary bond market but what do these commentators think that setting an explicit bond yield target does to secondary market functioning?
[7] As we showed in last week’s comment under Kuroda the BoJ’s balance sheet has ballooned to more than 90% of nominal Japanese GDP (three times bigger than either the ECB or the Fed) underlining the governor’s expansionist credentials.
[8] Refer to exhibit 1 above.
[9] See: Tily (2012) “Keynes’s monetary theory of interest” part of BIS Paper No. 65 “Threat of fiscal dominance?” – http://www.bis.org/publ/bppdf/bispap65.htm
[10] Despite the popularity of this investment theme it was always to our mind a nonstarter both for political and economic reasons. As Keynes pointed out in the General Theory “a monetary authority could set whatever long-term rate it chose, given the necessary domestic and international arrangements”. We discussed what domestic and international arrangements Keynes was considering in a Global Macro Themes note published last March see:https://amareos.com/research/files/amareos_debt_201503.pdf
[11] This risk has always seemed patently obvious to us but not many others for reasons we never fully appreciated.
[12] Legally the BoJ is prohibited from monetizing government spending in Japan. However, as we outlined in last week’s comment such rules can easily be circumnavigated see:https://amareos.com/blog/the-worlds-most-important-central-bank/
[13] Such an arrangement would expose the fallacy that a scarcity of Japanese government bonds is a limiting factor for policymakers.
[14] We first concluded that central banks – not just in Japan (albeit they would be first) but in other leading countries too – would eventually be forced to adopt yield targets (or caps) in 2009; we have had a long time to reflect on its significance.
[15] This, as much as the desire for a steeper yield curve, is why the BoJ likely set the target rate for the 10-year yield at zero – above the prevailing market rate.
[16] And, Kuroda’s objections to OMF will carry less weight.
[17] Unhedged, or partially hedged, of course, to benefit from the exchange rate move.
[18] We discussed this topic at length in the Global Macro Themes research note referred to in footnote 10. (We like footnotes, as you may have noticed!)
