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The BOJ Reaches its Policy Limit

Posted by Joseph Trevisani on Sep 21, 2016 1:51:50 PM

Has the Bank of Japan introduced modesty into its monetary policy by eschewing inflation promotion for interest rate targeting?

Governor Haruhiko Kuroda said on Wednesday that the central bank wants to keep the yield on the 10-year government bond at zero and will adjust its bond purchases to secure that goal.

For the past 3 1/2 years the Bank of Japan (BOJ) has been buying vast quantities of bonds, it now owns about 40 percent of the extant Japanese Government Bond (JGB) market. It has drenched the economy with liquidity in an effort  bring inflation to its 2 percent target. The failure has been notable. 

Inflation did surge in 2013 and 2014. The nationwide consumer price index (CPI) reached 3.7 percent in May 2014. But that was largely due to the 60 percent devaluation of the yen engineered by the then new Abe government and the BOJ.

This exchange rate manipulation, while successful in the short term had almost no effect on the underlying rate of inflation in the Japanese economy. Once the initial impact of higher import prices waned inflation subsided. By April 2015 annual CPI was back at 1.0 percent and in 16 months, in September 2015, it was again at zero.

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The continued bond purchases by the BOJ, while successful in driving down yields had negligible effect on the inflation rate. Annual inflation has slipped into outright deflation this year, with prices averaging -0.2 percent through July. 

Negative interest rates, introduced on a limited amount of commercial-bank deposits earlier this year have been no more successful at promoting inflation.

Interest rate targets have two problems, one of execution and one of concept.

In theory a rate target commits the central bank to buying an unlimited amount of bonds. It becomes the permanent bid if the market wants higher rates.

If for instance, the credit markets lose confidence in Japanese government economic policy and demand higher rates on bonds, the ensuing flood of sales would have to be bought without limit by the BOJ.  The ballooning balance sheet would be considered by many analysts an enormous economic distortion and the signal of a failed policy.

But for the Bank of Japan which is approaching ownership of half the nation's stock of government debt, the thought of adding another 10 or  15 percent in pursuit of a rate target may not hold much trepidation. 

The second problem with artificially induced interest rates is more telling.  There is no evidence that reducing interest rates, whether by rate targets or quantitative easing, especially from already historically low levels, has any appreciable effect on inflation rates.

Inflation is a relationship between the demand and supply of money. Central banks control only one side of that equation, the supply side.  Lower interest rates can boost the availability of money, but they can do nothing to alter demand.

As the Federal Reserve has discovered liquidity does not flow out into the economy unless it is called forth by loan demand. If there is weak demand, the billions in created liquidity sit as excess deposits or flow into the financial markets, boosting asset prices but not GDP.

The one unadulterated benefit of the BOJ new policy will be to bank profits which have been crushed by the flattening yield curve reducing the spread between near and long term rates.  Banks normally profit by funding long term and higher rate loans with cheaper short term borrowing. 

Market reactions divided after the BOJ announcement.  Equities soared, the Nikkei gained 1.9 percent, led by banks and insurance companies who stand to profit from the new policy.  

The yield on the generic 10-year Japanese government bond reached -0.002 percent, its highest since February, before closing at -0.027 percent. Bond yields move inversely with prices. 

The yen gained 2 percent against the dollar, rising above 101.00 for the first time since late August. One likely effect of the new policy is a reduction in the amount of bond purchases as the BOJ targets one specific area of the yield curve rather than its entire spectrum.

By targeting the 10-year JGB yield, which will do little to foster inflation, while maintaining its rhetorical commitment to higher prices, the BOJ is telling the markets that the bank has reached the effective limit of its policies.

The revival of the Japanese economy is now the responsibility of the Tokyo government.  

Joseph Trevisani

Chief Market Strategist

WorldWideMarkets Online Trading

Charts: Bloomberg

 

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