A Diversified BOJ Approach to Monetary Easing

“Side Effects” Become a Concern

At its Policy Board meeting on September 20 and 21, the Bank of Japan announced a new monetary policy package. One of the tools included in this package was yield curve control, which the bank described as a new method for effecting lower real interest rates. The BOJ’s aim, however, is not limited to this explanation.

The September Policy Board meeting also involved a comprehensive review of the BOJ’s current policy of quantitative and qualitative easing with a negative interest rate. Using the terminology of the BOJ, the review also considered the existence of side effects to monetary policies. The term “side effect” has not been used before in relation to monetary policies since Kuroda Haruhiko was appointed governor of the Bank of Japan. The significance of this subtle change should not be overlooked. After all, Governor Kuroda has not acknowledged a downside to the BOJ’s accommodative monetary policies, and the banking industry has been strengthening its criticisms of the central bank. Two months before the comprehensive review, Governor Kuroda spurned the industry’s complaints about a negative interest rate policy by stating that monetary policies are not executed to satisfy banks.

Banks reacted furiously to these remarks. This is because aggressive quantitative easing resulting in ¥400 trillion in JGBs on the BOJ’s balance sheet combined with a negative interest rate has made the yield curve far more flat, which is risking the sustainability of financial institutions and is interfering with the investment of long-term funds.

As noted in my August article at Nippon.com, as long as monetary policies influence the real economy through the intermediation of financial institutions, these institutions’ future stability cannot be ignored. Naturally, even if monetary policies are not executed to satisfy banks, their implementation can be impeded by actions that diminish their effect on the real economy and that magnify social uncertainties.

The Bank of Japan has engaged in massive quantitative easing with the aim of achieving its inflation target. While in theory that monetary easing may equal higher inflation, this is not the only factor that influences the real economy. If such an understanding has led the BOJ to modify its policies from the perspective of side effects, it is reasonable to say that the bank has begun to set aside its fundamentalism regarding monetary policy.

An Underlying Exit Strategy

What yield curve control might mean has yet to be digested by market participants. That is to say, what will be depicted by dual policy operations targeting the interest on the current accounts held by financial institutions at the BOJ and the interest for 10-year JGBs is still unknown. The BOJ says it will maintain an interest rate of –0.1% for the policy-rate balances in current accounts and an interest-rate target of around 0% for 10-year JGBs.

Since the announcement of the new policy package, the long-term interest rate has risen slowly, and the yield curve has steepened slightly. These changes, however, have been extremely modest. Even so, the BOJ has greeted these changes with some satisfaction due to concerns over the possibility of the long-term interest rate surging upward. This is why the central bank introduced new tools for market operations to facilitate yield curve control. It will purchase JGBs with yields designated by the bank (fixed-rate purchase operations), and it will extend the duration for fixed-rate fund-supplying operations from 1 year to 10 years. These new tools are second-best measures to prevent the sharp rise of the long-term interest rate.

How should the BOJ’s new policy framework be understood? Yield curve control is without question a policy to eliminate side effects. What can be discerned underlying this policy, however, is the BOJ’s search for an exit strategy. Naturally, the central bank will not state openly that it has begun a tapering process. Achieving a price stability target where the consumer price index increases 2% year on year remains a distant goal, and heedless statements that the bank has begun to taper would risk triggering sharp reactions in currency, stock, and bond markets.

Governor Kuroda in fact strongly denied that the bank is tapering at his regular press conference for September. However, he described the annual purchase of ¥80 trillion in JGBs in the new policy framework as a goal that may increase or decrease. A key issue will be whether this statement means that nothing has changed or that the BOJ will focus on decreasing rather than increasing JGB purchases.

Toward a Dual Approach to Monetary Policies

That said, there is no reason to expect dramatic changes ahead. While the recent global trend of doubting the effectiveness of quantitative easing will deserve attention, given the belief that dramatic changes in policy are certain to cause turmoil, the BOJ will be compelled to feel its way forward in implementing monetary policy. Thus, market participants will be fixated on reading between the lines of the BOJ’s statements.

For example, one BOJ official has stated that while an exit from quantitative easing will require a long period of time, this is not the case with the interest rate policy. It would not be mistaken to interpret this statement as suggesting that the Bank of Japan now sees an exit on the distant horizon.

This is the context to the BOJ reviving an interest rate policy by adding a negative interest rate to its quantitative easing and of augmenting existing policy to include yield curve control. It appears that the BOJ has adopted a dual approach to its monetary policies. While this might seem like a dramatic offensive move, it is better understood as being defensive in nature. The implication is that the BOJ has ended its singular focus on quantitative easing to assume a firmer monetary stance. While the path forward may be long, the bank is setting the stage to exit from current monetary policies.

Monetary Easing Is Not Limitless

Governor Kuroda is known to say that there is no limit to monetary easing. It cannot be the case, though, that the BOJ’s policy toolbox is unlimited in size. The bank is simply repeating stopgap policy operations.

In Lombard Street: A Description of the Money Market, a classic of monetary theory published in 1873, Walter Bagehot records what has come to be known as Bagehot’s dictum. This can be summarized as saying that the more a banker claims that his bank is sound, the more the bank is at risk. Applying this to Japan, it is possible to say that the more a central bank claims there is no limit to monetary easing, the more monetary easing is at an impasse.

A healthy rate of inflation cannot be achieved solely by monetary policy, whose effects are invariably accompanied by side effects. If such straight thinking is to replace monetary fundamentalism, debate within the BOJ will be insufficient. All manner of effective policies will need to be implemented, and private-sector efforts will also be essential. Governor Kuroda’s statement that monetary easing is limitless paradoxically reveals a central bank whose monetary policies have reached an impasse.

If Japan at this time loses sight of an exit to unprecedented monetary easing that even Bagehot, an outstanding economist and journalist, could not have imagined, the nation will be eternally confined to a world without interest.