An “elegant twist” in monetary policy by the Bank of Japan has shifted its focus to controlling bond yields rather than printing money, says Chief Economist Léon Cornelissen.
The central bank on 20 September set a target of zero for 10-year government bond yields and dropped the target for the average maturity of bonds that it buys as part of its massive quantitative easing program. The main interest rate was left unchanged at minus 0.1%.
The new measures are partly designed to offset the impact of negative interest rates on the Japanese financial industry, and it shows that the central bank still has some tricks up its sleeve amid fears that monetary policy is losing its effectiveness, Cornelissen says.
“The market had a bit of difficulty interpreting it because on the one hand the Bank of Japan disappointed, since they didn’t lower interest rates or increase the size of their QE package, or the nature of the assets they can buy,” he says.
“But they came up with some positive surprises, putting a cap or a bottom (depending on your point of view) on 10-year yields, by saying they will basically keep them around zero. They’re also dropping the intended average maturity of their QE program, thereby introducing more flexibility.”
“They’re clearly trying to control the yield curve as signaled by the introduction of a new acronym, YCC (Yield Curve Control), so that’s new. It’s an elegant twist of stunning simplicity by the Bank of Japan; the focus has changed to direct price control rather than the quantity of QE. So that’s a welcome change.”
“Equity markets reacted favorably because they see it as a signal that the bank doesn’t consider its arsenal to be empty. And nothing prevents the bank from shifting the yield curve deeper into negative territory if it feels the need arises.”
The bank is no stranger to springing surprises after introducing negative interest rates in January. However, a side effect was that bond yields fell dramatically, resulting in the zero target rate now placed on them, Cornelissen says.
“Banks and financial institutions generally are pleased that the Bank of Japan is now targeting the yield curve, because one worry was that negative rates were damaging the business model of the industry,” he says. “The 10-year yield had come down too fast, and banks in general like a positive yield curve (sloping upwards over time). So the central bank is now expressing sensitivity to this problem, which is why bank shares went up.”
Cornelissen says the flipside might be that the yield on the 10-year benchmark bond has now become in practice an ‘administrative price’ – an asset whose price is determined by the authorities rather than by market forces. There are precedents for this though, as the US Federal Reserve did this from 1942 till 1951 to combat the instability caused by the Second World War.
Another potential issue is the central bank’s new commitment to overshoot the inflation target of 2.0%Cornelissen says. “You could argue that this is a further radicalization of monetary policy, but with inflation currently at 0.5%, we are way off the target,” he says.
“And since the Bank of Japan basically is not introducing any new ideas to reach the 2.0%, let alone overshoot it, they have a credibility problem. It’s a bit like an athletics coach who sees his pupil failing to jump over 1.5 meters and then raises the bar to two meters.”
‘Nothing is preventing them from lowering interest rates further’
“Nevertheless, having such a commitment does suggest that the Bank of Japan will continue to do its utmost to stimulate the economy. And nothing is preventing them from lowering interest rates further now that they have yield curve control, with a target of zero on the 10-year bond yield.”
“With 30% of government debt on the Bank of Japan’s balance sheet, it is a good thing that they are loosening the target of the amount of debt they are buying, in favor of targeting the level of interest rate and the shape of the yield curve. So it’s not as though they have run out of ammunition. But what Japan really needs is structural reform, particularly in the labor market, along with some fiscal stimulus.”
“An interesting question is if the new Japanese policy can in principle be imitated by, for example, the European Central Bank. Targeting long yields in the Eurozone will potentially open a legal can of worms (imagine the ECB fixing the risk premium between Italy and Germany), but of course it could easily fix the German 10-year benchmark yield.”
Separately, on 21 September the US Federal Reserve did not change its monetary policy or interest rate, but signaled that it did expect a rate rise sometime in 2016, which is expected to come at the central bank’s December meeting. While politically independent, the Fed will now be reluctant to do anything so close to the Presidential and Congressional elections due in November.
“The next Fed meeting is 1-2 November, so that’s very close to the 8 November elections,” Cornelissen says. “No press conference is scheduled, and no new interest rate projections - the famous ‘dots’ - are scheduled, so clearly the Fed prefers not to act in November to avoid any semblance of political interference.”
“A December rate hike seems likely if the labor market continues to strengthen. The recent surprising weakness in the ISM services index, and to a lesser extent in the ISM manufacturing index (dropping below 50, signaling shrinkage) justifies the current cautious attitude of the Fed.”
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