The Bank of Japan has once again broken new grounds in monetary policy, now targeting not just the short-term policy rate but – within limits – the 10-year JGB yield. In practice the Bank will secure a positive yield curve against the backdrop of negative short-term rates and negative expected long-term real rates. This is meant to mitigate the debilitating effect of yield compression on the financial system and, probably, to contain the risk of bond yield tantrums in case domestic spending and inflation do pick up. As a side effect, the policy would subsidize long duration carry trades and long-long equity-duration risk parity positions.

The post ties in with the subject of non-conventional monetary policy.

The below are excerpts from various policy statements and research comments. Headings and some other cursive text has been added for context and convenience of reading. Sources are listed at the bottom of the post.

Motivation

“QQE [Quantitative and Qualitative Easing] has lowered real interest rates by raising inflation expectations and pushing down nominal interest rates. Although the natural rate of interest has followed a downward trend, real interest rates have been well below the natural rate of interest, leading to an improvement in financial conditions… However, the price stability target of 2 percent has not been achieved…This is largely due to developments in inflation expectations… Inflation expectations need to be raised further in order to achieve the price stability target of 2 percent.” [BoJ Comprehensive Assessment]

“The impact of interest rates on economic activity and prices as well as financial conditions depends on the shape of the yield curve… an excessive decline and flattening of the yield curve may have a negative impact on economic activity by leading to a deterioration in people’s sentiment, as it can cause uncertainty about the sustainability of financial functioning in a broader sense… if the negative interest rate were to excessively reduce financial institutions’ profits (deposit-taking institutions such as banks), this would make them more reluctant to lend…” [BoJ Comprehensive Assessment]

“The Bank was able to push down the entire yield curve in combination with large-scale purchases of JGBs [Japanese Government Bonds] under QQE and the negative interest rate policy introduced in January 2016…The fall in lending rates has been achieved at the expense of financial institutions’ profits. Thus, looking ahead, the policy effects of the decline in interest rates will depend on the impact on the profits of financial institutions and their lending attitudes reflecting such impact. In fact, lending rates have been on a declining trend in a severely competitive environment, and the pace of decline has accelerated since the introduction of the negative interest rate policy…The excessive decline in long-term and super-long-term rates lowers the rate of return on insurance and pension products and leads to the increase in firms’ pension benefit obligations…It is possible that such developments can cause uncertainty regarding the sustainability of the financial functioning in a broad sense, in that they could have a negative impact on economic activity.”[Kuroda]

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On the potentially debilitating effect of negative real and nominal interest rates on the financial system also view a previous post here.

“First, the Bank of Japan has hit the limit on how low and flat the yield curve should be from a policy effectiveness point of view… excessive flattening of the yield curve starts to be more harmful than helpful for the economy, as it can damage financial intermediation….Second, the BoJ is also inching closer to a practical limit on how many more JGBs it can buy, considering the fact that banks and insurers will not sell the JGBs they need to hold for collateral and liability-matching purposes.” [Masano]

Policy

“The Bank…decided to introduce ‘QQE with Yield Curve Control’ as a means of strengthening the existing framework for monetary easing…The new policy framework consists of two major components. The first is ‘yield curve control’ in which the Bank sets short-term and long-term interest rates as an operating target, and the second is an ‘inflation-overshooting commitment’ in which the Bank commits itself to maintaining an increase in the monetary base until the annual rate of increase in the observed CPI exceeds the price stability target of 2 percent and stays above the target in a stable manner.

  • Yield Curve Control…A combination of the negative interest rate and JGB purchases is effective in exerting an influence on the entire yield curve…Under the new framework, the Bank sets two key interest rates — the short-term policy rates and an operating target for the long-term interest rate — as a guideline for market operations. Specifically, for the short-term policy rate, the Bank uses the interest rate applied to the Policy-Rate Balances in current accounts held by financial institutions at the Bank, which is minus 0.1 percent, unchanged this time. For the long-term interest rate, the Bank sets a level of 10-year JGB yields as an operating target. The Bank conducts purchases of JGBs to achieve the target level. This time, the operating target for 10-year JGBs is set at “more or less at the current level (around zero percent)”. For other maturities, yields are expected to be formed in the markets consistent with the guideline for market operations…
    In order to control the yield curve smoothly, the Bank decided to introduce new market operations such as fixed-rate JGB purchase operations; that is, the Bank purchases JGBs at a price it designates. The fixed-rate purchase operations are intended to serve to cap long-term rates when necessary…Purchases of JGBs are conducted to achieve the target level of interest rates specified by the guideline for market operations at the time…It is anticipated that the pace may fluctuate to some extent, either upward or downward, in order to achieve yield curve control. Therefore, a possible change in the amount of purchases has no policy implication.
  • Inflation-Overshooting Commitment…The Bank decided to commit itself to expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food) exceeds the price stability target of 2 percent and stays above the target in a stable manner…This is an extremely strong commitment, in that it is linked to the observed CPI rather than the outlook for CPI…The commitment is to expand the monetary base. Its amount outstanding is currently about 400 trillion yen, which is already around 80 percent of nominal GDP. Corresponding ratios are about 20 percent in both the United States and the euro area. Looking ahead, the ratio is calculated to exceed 100 percent in slightly over one year, assuming that the Bank will continue with the current pace of increase in the monetary base.” [Kuroda]

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“The BoJ from now on will no longer target a base-money increase at an annual pace of ¥80 trillion but will target two specific interest rates: the overnight rate on part of excess reserves and the yield on the 10-year JGB. The average maturity target of seven to 12 years for the JGB purchase operation is now abolished; instead, the fixed-rate fund-supplying operation will be extended up to 10 years [from the current one year] and will be used, along with the JGB purchasing, to control the yield curve.” [Masano]

“The BoJ introduced a commitment to overshoot its inflation target as part of its new monetary policy framework, QQE with yield curve control. The Bank undertook to continue expanding the monetary base until the annual CPI inflation rate exceeds the 2% target and stays above it in a stable manner… The commitment has two theoretical strengths in raising inflation expectations… First, explicitly allowing the overshoots implies a longer period of monetary easing than the prior policy… Second, this new commitment is linked to the CPI’s past performance. This is called history dependence, which many analysts consider as optimal policy response…This commitment implies that the current policy is linked to the past CPI, and affects people’s current expectation that even if actual CPI inflation exceeds 2%, monetary easing will continue for the time being.” [Ugai]

Assessments

“With the BoJ aiming to fix both the yield curve and monetary base growth at the same time, the fundamental question, in our view, is whether the BoJ can succeed. Our answer is ‘no,’ if the BoJ takes a rigid approach. If the BoJ tries to fix 10-year yields, when bonds sell off, it would have to purchase more JGBs than originally planned, and vice versa, thereby losing control of the monetary base. Although such purchases could be highly pro-cyclical, we expect the BoJ will be flexible about yield curve control and monetary base growth… The BoJ’s yield curve control should help avoid excessive yield curve volatility.” [Kanno]

“The shift towards asset price targeting still leaves open the question of how central banks can boost aggregate demand and inflation. The BoJ’s ‘offence’ part was to announce an ‘overshooting-commitment’ to maintain expanding its monetary base until observed CPI inflation exceeds its inflation target of 2% and it also listed several options to ease further, including lowering the policy rates and additional asset purchases. But in the absence of more forceful fiscal stimulus, we are skeptical that the BoJ can do much to achieve its inflation target.” [Citi Research]

“The new framework is unlikely to boost the economy much by itself. This is because the new regime primarily changes the implementation of monetary policy rather than the degree of stimulus provided. A larger boost to the economy would require inflation expectations to be forward-looking and investors to see the overshooting commitment as credible. But neither appears to be the case…[However] the new regime should amplify the economic benefits of positive domestic shocks. For example, we show that a long-term yield target makes fiscal stimulus more powerful by suppressing the upward pressure on interest rates that would occur under the old regime.” [Goldman Sachs]

Sources

Bank of Japan, “Comprehensive Assessment: Developments in Economic Activity and Prices as well as Policy Effects since the Introduction of Quantitative and Qualitative Monetary Easing (QQE)”, September 21, 2016

Citi Research, “Global Economics View: The End Of QE – The Shift Towards Asset Price Targeting And Central Banks Playing Defence.” September 21, 2016 [no public link]

Goldman Sachs, “Global Economics Analyst Economic Implications of the BoJ’s New Regime”, September 23, 2016 [no public link]

Kanno, Masaaki, “The BoJ now controls the whole yield curve”, September 23, 2016 [no public link]

Kuroda, Haruhiko, “’Comprehensive Assessment’ of the Monetary Easing and ‘QQE with Yield Curve Control’”, Speech, September 26, 2016

Masano, Tomoya, “Bank of Japan: Yield-Curve Targeting Aims for Policy Longevity”, Post, September 21, 2016

Ugai, Hiroshi, “Japan: Will inflation-overshoot commitment raise inflation expectations?”, September 30, 2016 [no public link]