In a defiant speech earlier this month, Bank of Japan (BoJ) governor Haruhiko Kuroda insisted that there is plenty of ammo left in his monetary policy clip. With a comprehensive review of the effects of monetary policy on prices and the economy promised at tomorrow’s BoJ meeting, speculation is rife about what surprises could be in store as the central bank continues its war on deflation.
Interest rates could be cut deeper into negative territory. The BoJ might expand its already colossal balance sheet (456 trillion yen) with even more asset purchases. Japan’s financial institutions, in the meantime, will be hoping that the central bank changes its approach to buying government bonds, having felt their profitability squeezed since negative rates were first introduced in February.
Breaking the banks
While the yen has strengthened this year, hurting the competitiveness of the Japanese export market, negative interest rates have been passed on into the market as a whole and few analysts foresee any tightening in the foreseeable future.
“The central bank will likely conclude that monetary policy under Kuroda has largely been successful, thus giving the framework the thumbs up to be continued,” says Susan Joho, economist at Julius Baer.
But as the BoJ has hoovered up government bonds, the difference in the yield between short and long-dated bonds has narrowed. For insurers and pension funds, which rely on debt with long-dated maturities to cover their liabilities, this has been particularly painful. Similarly, commercial banks are being charged for keeping short-term deposits with the BoJ, and unable to charge their customers higher rates of interest. As a result, bank profits fell in August to their lowest since quantitive and qualitative easing began.
“I suspect they will find that negative interest rates have broadly been helpful,” says Guy Foster of Brewin Dolphin. “But the BoJ seems to have found some religion in the fact that a flat yield curve discourages bank lending and it is very negative for bank profitability.”
Shorter term debt
The yield curve could be steepened by reducing the average maturity of the 80 trillion yen of government bonds the BoJ has committed to purchasing every year. According to Valentin Bissat, economist at Mirabaud Asset Management, this policy would benefit the banking sector and would have “no negative impact on the private sector whose investment decisions focus more on maturities of seven to 15 years. Indeed, because of economic uncertainty, firms tend to borrow on a shorter horizon in Japan.”
However, the BoJ may not be explicit in announcing its willingness to steepen the yield curve. “Such a policy is risky if inflation expectations remain unchanged because monetary policy works through real interest rates,” says Bissat. “Moreover, the BoJ would send the wrong signal and a taper tantrum scenario could ensue.”
The BoJ currently requires that its Japanese government bond holdings have an average maturity of seven to 12 years. Altering this requirement “would give the BoJ more flexibility in a more and more illiquid market due to its own dominance,” says Joho.
Buying other assets
Indeed, some have pointed out that, at its current rate of government bond purchases, the BoJ will struggle with supply in three years’ time. Such is the scale of the BoJ's QE programme that it is buying bonds at more than twice the rate of new bond issuance planned by the Ministry of Finance.
Diversifying the type of debt on its balance sheet would give it longer. Along with a reduced average maturity on the 80 trillion yen of Japanese government bonds it buys every year, JP Morgan expects the BoJ to announce an extra 10 trillion yen of other asset purchases, including local government, corporate and government agency bonds at this week’s meeting.
Scrapping the explicit inflation target has also been touted as a distinct possibility. “The two year horizon to attain the 2 per cent inflation goal could be replaced by the phrase ‘as soon as possible’”, says Joho, putting the BoJ under less pressure to ramp up stimulus just before it reaches its deadline.
One of the biggest problems facing Japan’s deflationary economy is that markets simply don’t expect inflation to rise. Core inflation is currently only around 0.3 per cent, and the introduction of negative interest rates earlier this year produced little optimism that the country’s deflation is the stuff of history.
The BoJ’s research shows that long-term household inflation expectations have not risen since a 2 per cent yearly target was introduced in 2013, but some think that abolishing a target altogether would dash Japan’s hopes of ever approaching it.
“This target could be a long time away and is actually seen as one of Prime Minister Shinzo Abe’s biggest failures,” says Darius McDermott of Chelsea Financial Services. “But given that Japan has been in a pretty stagnant place for more than two decades, even a small amount of inflation is better than none.”