The Bank of Japan (BOJ) announced in September last year that it would be switching the focus of its quantitative easing program from monetary base targeting to controlling the shape of the yield curve (Bank of Japan, 2016). A brief comparison of the two frameworks is as follows. The previous monetary easing framework, Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest Rate, set out three policy dimensions: quantity, quality, and interest rates. The key targets were the yearly purchase of ¥80 trillion of Japanese government bonds (JGBs); the purchase of a smaller amount of various other assets, such as exchange-traded funds (ETFs), Japan real estate investment trusts, and corporate bonds; and a negative interest rate for current account deposits at the BOJ. The new framework, QQE with Yield Curve Control, leaves the quality and interest rate dimensions unchanged but signals a shift away from targeting a quantity of JGB purchases toward a commitment to fix 10-year JGB yields at around 0%, lifting them up from the negative rates that were seen under the previous regime. Coupled with the existing –0.1% rate on marginal reserve balances, which sets the short-term rates, the BOJ is targeting a steeper yield curve that will provide the necessary monetary stimulus while also providing relief to financial institutions, which typically hold long-term assets and short-term liabilities.
What are the differences between yield curve control and the previous regime?
In practice, the number of asset purchases is largely unchanged—the BOJ stated in its announcement that it would continue at a rate of around ¥80 trillion per year. Given that the BOJ has provided two different measures (the amount of assets to be bought, and yield curve control with two interest rate targets), there is some ambiguity in its guidance (Bernanke 2016b). There is also potential for conflict between the two targets: If ¥80 trillion is not the right amount of bond purchases required to achieve the desired yield curve, then will this figure simply be dropped? The ambiguity in its messaging provides the BOJ with flexibility but prevents it from setting clear expectations for market participants.
The question of whether or not the shift in regime will lead to fewer bonds purchased raises the prospect that this announcement may be the beginning of a tapering of the BOJ’s QQE program. This would set the scene for shortening the average remaining maturity of JGBs purchased, increasing long-term yields, and enabling a halt to further cuts in the negative interest rate. The BOJ will be keen to prevent the perception of tapering to avoid an adverse market reaction similar to the “taper tantrum” that followed the Federal Reserve’s tapering decision in 2013. Nevertheless, some will speculate that the BOJ may have been forced into “stealth tapering” because achieving its inflation goals may take much longer than previously expected, and the JGB market is becoming increasingly shallow. However, in its announcement, the BOJ reaffirmed its commitment to aggressive monetary easing in a different way by pledging to overshoot its 2% inflation target. In doing so, it has made a commitment to continue expanding the monetary base until the inflation target is exceeded in a stable manner, indicating that it may be prepared to tolerate above-target inflation for a period of time.
What are the advantages of the policy?
First of all, the policy is likely to reduce the number of bonds the BOJ is required to buy. It is expected that the BOJ will run out of JGBs to buy within a year or two if it keeps up the ¥80 trillion per year pace of purchases (Arslanalp and Botman 2015). The BOJ not only holds the majority of the JGB market, but also a large amount of ETFs. Maintaining the current scale of JGB and ETF purchases would drain liquidity from these markets, bring attendant governance issues to Japanese corporations, and could impede market functioning (Shirai 2016). By outlining a more sustainable system, this change in regime may boost confidence in the BOJ’s policy.
Second, the decrease in asset purchases that may arise from the change would help the BOJ control its balance sheet size. An enlarged balance sheet would expose the BOJ to a potential huge loss from a fall in value of its assets, but, by limiting the balance sheet size, the BOJ can attempt to place a ceiling on this risk.
Third, targeting a specific yield curve offers some degree of greater certainty to investors. Knowing that the BOJ will revise its purchases upward or downward in order to achieve the target should enhance confidence in the BOJ’s monetary policy outcomes.
Fourth, a steeper yield curve will alleviate some of the pressure on commercial banks and pension funds—a flatter yield curve reduces the profits for both industries. A healthy financial sector is key for the BOJ’s aim of a growing economy with price stability, so the degree to which the steeper yield curve benefits financial functioning will be an important factor in the success of the yield curve control policy.
Additionally, relieving some of the pressure on the financial services industry in this way may give the BOJ better scope to lower the deposit rate further into negative territory if necessary, as some of the negative impact on the financial sector will already be partially offset by the steepened yield curve.
What are the risks?
First, if there were to be a need for further monetary easing, it is not clear which of the two interest rate targets would be lowered. More guidance on the BOJ’s next steps would be welcome.
Second, the effects of maintaining yield curve rates within a rigid band over a long period are uncertain. Pricing in financial markets could be distorted, impeding market functioning. Long-term interest rates carry with them a great deal of economic information: inflation expectations and expected potential growth, for example. It may take a long time to achieve the 2% inflation target; until then the information contained in the long-term rates will be distorted and could lead to inefficiencies and reduced liquidity.
Third, the BOJ may in the future face the dilemma of whether to counter deviations arising from a temporary shock, even at a high price, or whether to tolerate movements at the risk of undermining the credibility of the yield curve targeting. This has already been tested to some extent by the global increase in bond yields that followed the United States presidential election. In that instance, the BOJ was able to restrict the rise in JGB yields very effectively by offering an unlimited amount of JGB purchases at fixed rates (Shirai 2017). This offers promising evidence for the BOJ’s ability to enforce its yield curve targets, but this success must be replicated in the face of future events.
Our final concern is that for purely operational reasons, it might not be easy to peg the long-term interest rate (Bernanke 2016a). The yield curve does not adjust precisely according to the interest rate or government bonds purchases, so fine-tuning is likely to be difficult. The BOJ may face market fluctuations and larger risks, such as investors’ sudden dumping of JGBs or other external shocks arising from unexpected geopolitical or economic events.
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References:
Arslanalp, S., and D. Botman. 2015. Portfolio Rebalancing in Japan: Constraints and Implications for Quantitative Easing. IMF Working Paper. Washington, DC: IMF.
Bank of Japan. 2016. New Framework for Strengthening Monetary Easing: Quantitative and Qualitative Monetary Easing with Yield Curve Control. Tokyo: Bank of Japan.
Bernanke, B. 2016a. What Tools Does the Fed Have Left? Part 2: Targeting Longer-Term Interest Rates. 24 March. Brookings Institution.
Bernanke, B. 2016b. The Latest from the Bank of Japan. 21 September. Brookings Institution.
Shirai, S. 2016. 白井さゆり 慶應大学教授 「＜日銀検証＞を検証する」（2）2016.10.21. [Sayuri Shirai, Professor at Keio University “Assessing the BOJ’s Assessment”]
Shirai, S. 2017. Mission Incomplete: Reflating Japan’s Economy. Tokyo: ADBI.
Photo: By Rdsmith4 (Own work) [CC BY-SA 2.5], via Wikimedia Commons
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