BoJ: Scraping the barrel?

Investor eyes this week are firmly on monetary policy, with the Fed and BoJ both meeting on Wednesday. But while the FOMC is widely expected to leave policy unchanged, there is absolutely no consensus on what the BoJ’s Policy Board might have up its collective sleeve. Market participants are divided on whether the BoJ will even ease further, let alone agree on what form such easing might take. Given such uncertainty, a financial market reaction to whatever the BoJ announces seems certain.

Ill communication

Uncertainty surrounding the BoJ’s next move is partly a function of its communication strategy. The element of surprise has been central to Kuroda’s game-plan to try to over-deliver, leaving no doubt about his commitment to meeting the BoJ’s 2% inflation target. But while in his early days Kuroda’s shock tactics appeared to boost inflation expectations, the impact proved short-lived. And the subsequent steady decline in inflation expectations over the past couple of years, reflected in surveys and financial market indicators alike, highlights an alarming loss of credibility. Indeed, the BoJ’s recent actions have left the impression that it is now scraping the barrel of policy options, with January’s landmark shift to a negative rate – a policy that Kuroda had previously implied was unworkable – appearing an act of desperation, and the most recent move – July’s increase in purchases of ETFs – a token gesture likely to have minimal macroeconomic impact.

BoJ still looking on the bright side

Investors are also confused over how the BoJ assesses the economic situation. While business surveys remain humdrum, data released since its July meeting showed that GDP expanded in Q2 for the third quarter out of the past four, with output 0.7% higher than at end-2015 – not necessarily something to shout about, but probably above-potential. Other figures suggest that domestic demand is providing ongoing support in Q3. And with Abe’s fiscal stimulus set to provide a positive impulse to growth over coming quarters, the BoJ might remain sanguine about the economic outlook. Certainly, if it is unwilling to acknowledge the likelihood that it will eventually need to revise its most recent economic forecasts – which in July predicted GDP growth of around 1% each year through to FY19 and inflation rising to target by the end of FY17 – the Policy Board would also seem likely to find no pressing need to ease policy further.

Ready to re-boot?

Following the particularly ill-received negative rate announcement, the BoJ’s comprehensive assessment of policy under Kuroda, commissioned in July and due to be discussed by the Policy Board this week, provides an opportunity for Kuroda to press the re-boot button. But rather than offering constructive self-criticism, recent comments by Kuroda and other senior BoJ officials suggest the comprehensive assessment will primarily be an exercise in self-justification, concluding that the BoJ has been right all along. Central to its case will be the further downwards shift in nominal interest rates since the start of the year. While it will remain unsaid that the biggest winner from the drop in debt interest costs is the government, firms with capital market access have enjoyed all-time low yields, and new corporate bond issuance has jumped sharply, with a record amount already raised for a third quarter and a notable increase at longer maturities. Moreover, lower bond yields have been passed on in the normal way to lower rates on bank loans, supporting demand for investment and housing and providing savings for existing borrowers via debt refinancing.

Get real!

With inflation expectations having fallen faster than nominal yields, however, real interest rates have actually drifted higher, representing a tightening of financial conditions. Moreover, as every major central bank acknowledges, monetary easing has uneven effects, with losers as well as winners. Interest rates on deposits have inevitably been cut further from what were already miniscule levels, with some firms’ large-scale deposits facing negative rates. While that is arguably desirable, it has meant that bank net interest margins have been squeezed and – given that the stock of deposits far exceeds that of loans and margins have been squeezed steadily for several years – significantly so.

BoJ sensitive to the banks

Admittedly, the BoJ has long been mindful of the possible negative consequences of its policy on the banks. Indeed, the tiered interest rate framework seeks to dilute the effect, ensuring that banks still receive a positive average return on their current account deposits at the BoJ (6.3bps last month). Banks have meanwhile benefited from capital gains on their JGB holdings, as well as an ongoing improvement in asset quality reflected in the continued downtrend in bankruptcies and domestic NPLs. Nevertheless, it knows that the longer that net interest margins are squeezed, the greater the risk that damage could eventually be done to financial intermediation and – by extension – the real economy. Moreover, the BoJ is also wary of the adverse consequences of a much flatter yield curve for insurers and pensions. And as institutional investors increasingly sought to substitute their domestic bonds for overseas securities, pressures on dollar funding premiums have risen too –a further adverse consequence of current BoJ policy.

Carry on regardless with negative rates

While the BoJ is mindful of these adverse side-effects from its actions, all recent statements from its senior officials suggest that it remains firmly of the view that the benefits of its current framework outweigh the costs. In his speech on 5 September, Kuroda left little room for doubt, judging that there is no sign yet of any damage to financial intermediation – given survey evidence of an easing of credit standards, he suggested the opposite appears to be the case. Indeed, he effectively pre-empted the findings of the comprehensive assessment in emphasising again that “there is still ample space for further cuts in the negative interest rate”. So, we expect Wednesday to bring a reaffirmation of the BoJ’s readiness to ease policy via another rate cut. And last week’s report in the Nikkei newspaper that the BoJ will assign the negative rate as the primary tool for easing going forwards – in the words of the article, “the centrepiece of future monetary easing” – had a credible ring to it.

Countless ways to tweak QQE

Despite the likely emphasis to be placed on negative rates from now on, QQE will not be abandoned. And with Kuroda having stated that “a reduction in the level of monetary policy accommodation… will not be considered”, we don’t expect the monetary base target to be reduced from the current rate of increase of ¥80trn per year. Nevertheless, with no shortage of concerns – from worries of a possible future limit to the BoJ’s ability to buy JGBs at the current rate to the aforementioned discomfort related to exceptionally low yields on super-long JGBs – the BoJ might announce tweaks to the asset purchase programme, such as the addition of other bond classes. Greater flexibility around the average maturity of the BoJ’s JGB purchases (currently about seven to twelve years) would not be unreasonable, nor would measures to address a possible future collateral shortage, which could reduce fears of tapering. But we would definitely rule out purchases of foreign bonds while the setting of a yield curve target also seems unlikely.

More heat than light?

So, overall, we expect Wednesday to see a strengthening of the status of the negative policy rate and tweaks to QQE. But while there is also an off-chance of unforeseen new action to give a jolt to inflation expectations, this is unlikely to be more than a gesture and we do not expect any truly substantive easing. Indeed, after the massive expansion of the BoJ balance sheet over the past few years, the scope for that within the current legal framework is limited.

It’s macro, not just monetary policy that matters!

Yet despite all the excitement surrounding Kuroda’s activities since early 2013, Japan’s experience – not least the way by which the misguided 2014 consumption tax hike snuffed out the progress of the first phase of Abenomics – highlights that it is macroeconomic policy in the round, and not just monetary policy, that matters. And while better than nothing, Abe’s latest fiscal stimulus seems unlikely to give the BoJ the kind of help it needs to place GDP growth onto a significantly higher plane. So, while we expect underlying inflation to inch higher over coming months, return to positive territory at the start of 2017, and edge closer to 1%Y/Y next summer, the 2% target might still be no more within reach than it was when Kuroda launched QQE in 2013.

Another rate cut for the New Year?

The BoJ will not be ready to admit that just yet. Nevertheless, with the policy rate to be given primacy and the Policy Board likely to make clear in its forward guidance its readiness to ease monetary conditions further if necessary to achieve and sustain the target “at the earliest possible time”, the BoJ will likely act again before long. Expect a further cut to the negative policy rate in due course, most likely in the New Year.

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