Holding the Bank of Japan captive

It is premature to conclude that the Bank of Japan will increase its ten-year government bond yield target in line with rising US Treasury yields. Fiscal dominance, meaning the extent to which fiscal deficits constrain monetary policy, is weighing on the central bank’s independence. With a long road to recovery ahead, even greater collaboration between the government and central bank cannot and should not be ruled out. We look for a widening divergence between Japanese and US government bond yields, all the way down the curve.

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Benefiting from global tailwinds and US monetary policy divergence, the Bank of Japan left policy unchanged when it concluded its two-day rate-setting meeting earlier this month. But, as we have argued in the past, relying on positive overseas developments is not a sustainable strategy. Greater collaboration between the Japanese government and central bank, in the form of a money-financed fiscal expansion, is required.

Although this policy prescription, commonly referred to as helicopter money, is untried and untested, the Bank of Japan has often been at the frontier of innovative policy. Japan pioneered the use of quantitative easing long before the rest of the world joined in. Quantitative easing of any sort drives a coach and horses through the concept of central bank independence – once QE is in place, the lines between fiscal and monetary policy are extremely blurred. Given the size of the Bank of Japan’s balance sheet, the leap to helicopter money might not be as great as many imagine. In fact, in announcing its yield curve target last September, the Bank has implicitly agreed to buy and sell ten-year Japanese government bonds in unlimited quantities.

This is part of a broader shift, with fiscal policy coming back into the frame as the monetary medicine struggles to resuscitate Japan’s economy. Indeed, attempts to tighten fiscal policy and start to reduce the mountain of government debt have stalled. But with an already bloated public sector balance sheet, to head off concerns about the cost of financing further government borrowing, the central bank has been persuaded to finance the government deficit and suppress bond yields — ushering in an era of fiscal dominance. A central bank-financed fiscal expansion may follow.

Fiscal dominance will ultimately mean the Japanese yen will weaken significantly further from here. But for the time being, with the global reflation trade and expectations of monetary policy divergence helping to weigh the yen down, our central scenario assumes that the Bank of Japan refrains from doing anything radical, such as helicopter money, within our two-year forecast horizon.

To the extent that the government deficit is already constraining the Bank’s behaviour, and with consumer price inflation weak, we also believe that the Policy Board will refrain from adjusting its ten-year government bond yield target in line with rising US Treasury yields.

Indeed, with an average annual gross financing need equivalent to around 30% of Japan’s nominal GDP, policymakers have a strong incentive to keep interest rates low and contain the government’s debt servicing costs. Moreover, the terms of the two Policy Board members (Mr Sato and Mr Kiuchi)  that have continued to vote against keeping ten-year yields at “around zero” are due to end in July.

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Speaking after this month’s Monetary Policy Meeting, Governor Kuroda resorted to forward guidance in a bid to counter rising interest rate expectations. Pointing to below target inflation, which — based on the median of Policy Board members’ forecasts — will not reach 2% this year or next, he argued that it is appropriate to continue with the current framework of powerful easing. The Summary of Opinions from this month’s meeting, released on Monday, struck a similar tone. One member suggested that “it will be a considerable amount of time before the Bank will need to change its monetary policy.”

Japan has had more success in suppressing bond yields than its peers, but its forward commitment in this respect is likely to involve increasingly large purchases of Japanese government bonds by the central bank. We believe that the Bank will step up its bond purchasing if deemed necessary to keep yields down. Consequently, we look for a widening divergence between Japanese and US bond yields, all the way down the curve, to an even greater degree than will be the case for other developed economy government bonds.

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Given the prospects for growth and the primary balance, even if the new policy mix of fiscal dominance succeeds in holding yields at “around zero” it will not be sufficient to stabilise the ratio of government debt to GDP[1]. To change that, a radically different approach will be needed. The final step, the coup-de-grace of fiscal dominance, would be to create an imbalance between the assets and the liabilities on the Bank of Japan’s balance sheet. The clearest way of doing that would be to write off a portion of the assets, so the government defaults on its own central bank.

More likely, though, would be a kind of sleight-of-hand, redenominating those assets as zero-coupon perpetual bonds, whose mark-to-market value is zero, but whose face value is the same as the existing assets. For us, either of those options would imply a radical departure from past policies. Helicopter money (for that is the name for such a policy) could ‘work’, in the sense of radically reducing the debt ratio through default (explicit or implicit) and inflation. But the unintended consequences could also be large — these are uncharted waters.

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[1] We have assumed a nominal GDP growth rate of 1.2% and a primary balance to GDP ratio of 6.5% (the annual average between 2011-2015).

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