Japan’s economy continues its moderate recovery. GDP growth for January to March this year was 1 percent, slightly above the potential growth rate of around 0.8 percent. The data since suggests a somewhat stronger pace of recovery due to favorable real exports and business fixed investment. Meanwhile, households’ real consumption has not shown rising trends despite good employment conditions. The underlying inflation (the consumer price index excluding food and energy) has remained in negative territory. Given this mixed performance, the issues surrounding the Bank of Japan’s monetary easing framework have increasingly become complicated and uncertain.
First, the BOJ continues to insist that the timing of reaching about 2 percent is likely to be around fiscal year 2018 even though such a projection is rejected by almost all economists. While inflation is expected to rise toward 1 percent by this fall, mainly due to the base effect (from a weakening impact of the previous oil price drop), underlying inflation is expected to rise less without upward price pressures on services. Their long-term average inflation projections over the next 10 years remains below 2 percent.
Second, as the current monetary easing framework has distorted the financial and capital markets deeply and at an unprecedented level, there is growing anxiety about what would happen to these markets if the BOJ continues with its current monetary easing framework for many more years. The declined functioning of the Japanese government bond (JGB) market is especially a growing concern given its disproportionately large size in the debt-securities market and its role in providing a benchmark for pricing corporate and other bonds. Moreover, growing concerns are being raised over the declined market functioning in the stock market due to the growing presence of the BOJ as a large investor and its impact on reducing the downside risk.
The concerns are also growing because the positive marginal impact of the framework is clearly waning. Households continue to allocate half of their financial assets to deposits and cash. Their portfolio rebalancing is limited since households reduced equity holdings from 20 percent in fiscal year 2012 to 17 percent in fiscal year 2016 despite a sharp stock price hike since late 2012. Households are unlikely to increase consumption beyond their means due to the low deposit rate (hence limited asset accumulation) and limited alternative financial assets (for example, a decline in the number of saving-type insurance products due to low returns) in addition to the sluggish income outlook.
Companies keep most of their profits in banks rather than allocating them to business fixed investment or overseas foreign direct investment. If the nominal long-term interest rate is set at the current zero percent target level (so the term premium remains negative), the corporate sector may be discouraged from restructuring unviable businesses, thereby exerting downward pressures on Japan’s productivity and potential economic growth. Financial institutions may find it hard to perform healthy financial intermediation due to the difficulty of properly pricing the creditworthiness of borrowers. The government may lose a sense of urgency to raise the potential economic growth necessary to increase tax revenue.
Third, the BOJ’s ambiguous, self-contradictory monetary policy framework has confused the public and markets. In September, the BOJ announced a 10-year yield peg at around zero percent and simultaneously stressed the continuation of the annual pace of net JGB purchases of about ¥80 trillion. Nevertheless, the BOJ reduced JGB purchases toward ¥50 to ¥70 trillion most of the time from September 2016 to the present. Without reducing net purchases of JGBs from ¥80 trillion, the yields would have declined further, given strong demand for the JGBs from banks and life insurers.
While reducing JGB purchases is done to achieve the zero percent yield target, raising nominal interest rates and hence real interest rates, given no rising trends in long-term inflation expectations over the period according to Tankan Summary of Inflation Outlook of Enterprises, is contradictory to the BOJ’s view that the main transmission mechanism of monetary easing is to push down real interest rates, as described in the Comprehensive Assessment of Monetary Easing — released in September 2016 together with the announcement of yield curve control. The media has paid attention to the inconsistency between what is written in the Statement on Monetary Policy (about ¥80 trillion) and what is actually done by the BOJ, and has asked the governor for explanations at news conferences. Many reporters feel that satisfactory, concrete answers have not been given.
On the morning of July 7, 10-year yields rose to 0.105 percent in response to a hike in European yields. The yen depreciated against the euro but appreciated against the dollar due to a decline in the U.S. long-term yield. The BOJ then attempted to reduce the yields by using unlimited fixed-rate (0.11 percent) JGB purchase operations on the 10-year maturity as well as an increase in regular JGB purchase operations (also on July 12) mainly on the same maturity. As for the former, there were no bids (unlike the previous cases in November and February) since the yield offered was higher than the market rate. The BOJ used it as an announcement that its defense line is 0.11 percent. This led to a temporary depreciation of the yen against the dollar.
Japan’s long-term interest rates are expected to stabilize at around zero percent for the time being since they face two counteracting forces: downward pressure from domestic investors’ strong appetite and upward pressure from rising yields worldwide. The BOJ is expected by market participants to maintain the current ambiguous monetary easing framework and communications strategies at least until Gov. Haruhiko Kuroda’s term ends next April. Eventually, however, the BOJ will need to clarify its monetary policy stance. But doing so would need to be carefully timed as it may result in a shift of short-term oriented investors’ positions from short to long positions in the yen.
Sayuri Shirai is a professor at Keio University and a former BOJ Policy Board member.