One week on from the Bank of Japan’s (BoJ) surprise announcement that it has moved away from monetary base targeting and instead is now focusing on yield-curve control (YCC), the market has had sufficient time to ‘vote’ on its assessment of the new policy regime. If the BoJ’s intention was to change its monetary policy framework, and reconfirm its commitment to its 2% inflation target and the effectiveness of its monetary policy tools, an objective scorecard might look something like the below:
i.e. a mixed result. We are sceptical that the BoJ’s new policy regime will be successful. Crucial to the success of the BoJ’s change in policy framework will be the credibility of the BoJ’s commitment to hit and maintain current policy settings until inflation is stably above 2%, if indeed current policy settings are able to raise inflation expectations at all. Raising inflation expectations would serve to lower long-term real yields and offset the steepening in the nominal yield curve that the BoJ has sought to engineer to help banking sector profitability. Unfortunately this process is unlikely to be straight forward. As a life-long Liverpool Football Club fan, I believe Liverpool FC is still the best football team in England, although the empirical evidence of Liverpool’s failure to win the league in 25 years suggests otherwise. Similarly, inflation over the past 10years in Japan has averaged 0.3% year-on-year and 10-year Japanese inflation break-evens of 0.3% suggest the BoJ’s inflation credibility is more that of a relegation candidate than a Premier League champion.
In addition, the BoJ has attempted to emphasise its inflation credibility at a point when Japanese inflation is likely to move lower, driven by the recent appreciation of the Japanese yen. The BoJ itself has noted that inflation expectations in Japan appear very adaptive, i.e. based on recent experience. A move lower in measured inflation over the balance of this year is likely to be unhelpful in the BoJ’s objective of raising medium-term inflation expectations.
The BoJ’s attempts to control both the price (targeting 10-year yields around 0%), and quantity (continuing to target a monetary base expansion of ~80 trillion yen per annum) of money, also looks doomed to failure. If JGB yields decline and the yield curve starts to flatten, driven for example by domestic or international economic developments, the BoJ presumably under the YCC framework should start to purchase less 10-year and longer maturity JGBs (we presume they would not start to sell JGBs in an attempt to raise yields), effectively moving away from their 80 trillion yen per annum monetary base expansion target. The currency markets are likely to interpret this as tapering from the BoJ, pushing the yen higher, and exacerbating the challenge for the BoJ. The alternative for the BoJ would be to purchase significantly greater proportions of short maturity JGBs, although this would represent nothing more than a short-term solution given the high proportion of outstanding bonds the BoJ already owns of this sector of the yield curve. The BoJ could also cut rates further into negative territory, but this would increase pressures on domestic banks (which is something the BoJ seems keen to avoid), and the effectiveness of negative rates in stimulating real economic activity in Japan remains uncertain.
Therefore, it seems the BoJ change of monetary policy framework has done little to address the market’s concerns that the BoJ is running out of effective tools to ease policy. Meanwhile, the downgrade of the longer-term dots by participants at the September FOMC meeting suggests that markets are right to be sceptical on the prospects of medium-term policy divergence between the Fed and the BoJ, which has been an important driver of a lower USDJPY rate.
In terms of what this means for the likely future direction of USDJPY, the JPY has out-performed the USD by ~19% YTD and the yen is no longer extremely undervalued vs. the USD, although PPP fair-value estimates of USDJPY are still in the low 90s. We believe that in the absence of significantly higher rates in the US (which we don’t foresee), or a significant increase in medium term inflation expectations in Japan (which again we don’t foresee in the absence of debt monetisation), USDJPY continues to be biased lower as Japanese domestic investors continue to reduce their significant foreign currency exposure which they accumulated over the past decade when expectations of future policy divergence were more elevated.