Seeking an Exit Strategy from the Bank of Japan’s Extreme Monetary Easing

Kuwabara Minoru [Profile]

[2017.07.24] Read in: 日本語 | 简体字 | Русский |

How does the Bank of Japan intend to exit from quantitative and qualitative easing? Having reported on monetary policy over many years, the author anticipates the steps the BOJ is likely to take and examines the risk of monetary policy being affected by fiscal policy, the BOJ’s accountability, and the risk for the depreciation of the yen.

Massive Holdings of Japanese Government Bonds

In April 2014, the Bank of Japan eased its monetary policy and began to purchase massive quantities of Japanese government bonds. Through this policy of quantitative and qualitative easing (QQE),1(*1) JGBs held on the BOJ’s balance sheet rose to ¥420 trillion (of which ¥390 trillion are long-term JGBs), or more than 40% of JGBs outstanding. In comparison, the Federal Reserve Board holds 12% of US Treasuries outstanding. Few other central banks have as many government bonds on their balance sheets as Japan’s does.

The BOJ has established a policy target of 2% for the growth rate of the consumer price index. Once this target is achieved, it will begin to unwind its extreme quantitative easing. If this is accompanied by the gradual rise of interest rates, turmoil in markets will be limited. Concerns, however, are growing among market participants that the long-term interest rate will rise sharply. The shock of a sudden increase in interest rates will hit the earnings of financial institutions. Hence, there are mounting calls for the Bank of Japan to disclose specific simulations of its exit from monetary easing so markets can anticipate the trend for interest rates.

Negative Interest Rate Hits Bank Earnings

The April publication of a document on the BOJ’s monetary policies by the Administrative Reform Promotion Headquarters of the Liberal Democratic Party prompted the current apprehension over BOJ exit strategies. The document raised such issues as whether the insolvent state of the BOJ with its massive holdings of JGBs would lead to a loss of confidence in the yen and in Japan as a whole, whether the earnings of financial institutions would be squeezed from the increase of the interest rate for reserve deposits when exiting from monetary easing, and whether the soundness of government finances would be harmed by the sharp rise of interest rates for JGBs. These issues are currently being discussed from a range of perspectives.

Another issue facing the BOJ is the growing difficulty of purchasing ¥80 trillion in JGBs annually (the current level of purchases is around ¥60 trillion). This figure already exceeds the annual government issue of the bonds. As a result, the BOJ is only able to achieve its purchase target by acquiring JGBs on the secondary market with a negative interest rate (over par issue).

Naturally, the BOJ will record a loss when JGBs purchased with a negative interest rate are redeemed. Whether this is a sustainable policy is highly doubtful. Since current policy will clearly need to be terminated at some point in time, the demands of market participants for clarity about exit procedures and for the disclosure of exit simulations are extremely reasonable.

The ill effects of QQE are spreading. A zero or negative interest rate policy pursued over the long term has reduced the lending spreads of financial institutions and is suppressing their earnings. Banks’ diminished risk buffers are curtailing their capacity to extend new loans.

Since the BOJ’s intervention has removed so many JGBs from the secondary market, daily trading has contracted, and the long-term interest rate is fading in the Japanese market as a useful indicator. While JGBs are seen as having unparalleled creditworthiness, their interest rate is no longer serving as a reliable indicator. Without an indicator for long-term interest, there will be no basis for fixing the interest rate for corporate bonds. The same can be said for the interest rate for housing loans. Such a situation will unsettle the finances of companies, and financial institutions will be reluctant to make long-term loans.

The Broken Promise of Short-Term QQE

QQE was intended to be a short-term monetary policy that would last for two years. However, major changes in the economic environment, such as the decline of crude oil prices, compelled the BOJ to keep this policy in place for a longer period. Now that more than four years have passed, CPI is trending near zero despite the BOJ’s policy target of 2% inflation. As long as the BOJ holds to its 2% target, it will likely maintain its QQE policy.

Now is the time to carefully consider whether 2% should be an absolute target. While this level of inflation has not been achieved, a weaker yen and higher share prices, which were the initial covert targets of QQE, have been realized (BOJ Governor Kuroda Haruhiko was able to persuade foreign central banks that QQE was a domestic monetary policy and not a foreign exchange policy).

Abenomics also won acclaim for achieving a weaker yen and higher share prices rather than attaining a 2% increase in CPI. Since prospects for a deflationary economic spiral have waned, the downward revision of the CPI target should be considered in monetary policy.

In the April Outlook for Economic Activity and Prices, the BOJ states, “The timing of the year-on-year rate of change in the CPI reaching around 2 percent will likely be around the middle of the projection period—that is, around fiscal 2018. Thereafter, the rate of change is expected to remain at around 2 percent.” The inflation forecasts of Policy Board members are also on the high side, with the median being 1.7% for fiscal 2018 and 1.9% for fiscal 2019.

As depicted in the chart, the slope of the graph has become far less steep in 2017, and its current shape can no longer be called realistic in relation to the policy target. The BOJ has revised its CPI outlook five times since instituting QQE. Can there still be anyone who believes in this outlook?

(*1) ^ To supplement the limits of monetary policy, the BOJ instituted a negative interest rate policy in January 2016. Then, in September 2016, it began Yield Curve Control where the interest rate for 10-year JGBs is held to 0%.

  • [2017.07.24]

Nippon.com senior editor. Born in Tokyo in 1952. After graduating from the Faculty of Law of Chūō University, joined Kinzai Institute for Financial Affairs, Inc., where he became deputy bureau chief, editor of the weekly Kin’yū zaisei jijō (Financial Affairs Journal). Assumed his current position in 2017.

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