- The condition for BOJ normalisation under the current policy guidance is not yet fulfilled
- Revising the 2% inflation commitment could reduce transparency and undermine credibility
- A rapid yield rise could hurt fiscal sustainability, financial stability, and the real economy
- Relaxing YCC remains the most likely option in the near term
- Odds of YCC exit are rising for the 2H23-2024 period
Kazuo Ueda will become the next BOJ governor
It has been widely reported since last Friday that Prime Minister Fumio Kishida will nominate Kazuo Ueda as the next governor of the Bank of Japan. He is expected to submit Ueda’s name to the parliament on 14 February, with hearings on the nomination to take place on 24 February. This decision came as a surprise to many investors. For months, the front-running candidates were always the incumbent and former deputy BOJ governors Masayoshi Amamiya and Hiroshi Nakaso.
Ueda is currently a professor at Kyoritsu Women’s University. He served as a former BOJ policy board member two decades ago during 1998-2005. In his earlier career, he also taught at the University of Tokyo and the University of British Columbia in Canada. Apparently, he has not been associated with the ultra-loose monetary policy pursued by the incumbent governor Haruhiko Kuroda in the recent decade. Compared to the other candidates, Ueda may be relatively less constrained and more innovative in policymaking.
Nonetheless, there is no evidence that Ueda is inclined for drastic policy changes in the near term. During a latest TV interview last Friday, Ueda said that the current BOJ policy is appropriate and monetary easing must carry on. In an opinion piece published on the Nikkei in July 2022, he wrote that the BOJ should not prematurely tighten monetary policy just because inflation briefly exceeded 2%, while it should consider an exit strategy at some point in future. During his term as the former BOJ board member, Ueda voted against ending the zero interest rate policy in 2000 and voted for the launch of quantitative easing in 2001. On the other hand, he also openly expressed concerns about the effectiveness and the costs of unconventional monetary easing during public speeches and research papers. His full thinking on monetary policy is not yet clear, but the available information suggests that he tends to adopt a balanced and pragmatic approach on policy matters.
Meanwhile, there is also no evidence that Kishida’s administration is keen in monetary policy changes in the near term. In addition to Ueda, Kishida is reportedly to nominate Shinichi Uchida and Ryozo Himino as the new deputy BOJ governors. Uchida is the BOJ’s executive director in charge of monetary policy at present and is considered as a key figure in drafting and implementing Kuroda’s ultra-loose policy. The selection of Uchida as a new deputy governor may indicate the government’s bias towards monetary policy continuity in the near term.
A stable 2% inflation is not yet achieved
Under the BOJ’s current policy guidance, achieving a stable 2% inflation rate is the essential condition for policy normalisation. This condition is not yet fulfilled:
- Headline, core, and core-core CPI surged to 4.0%, 4.0% and 3.0% YoY respectively in Dec22. Among the BOJ’s measures of the underlying inflation, the trimmed-mean CPI also reached 3.1% in Dec22, but the weighted median and the mode remained at around 1.5%. At the latest January meeting, the BOJ projected that core CPI will ease from 3.0% in FY22 to 1.6% in FY23 and 1.8% in FY24, core-core CPI will also ease from 2.1% to 1.8% and 1.6%.
- GDP deflator, as a broader price measure, remained negative at -0.4% YoY in 3Q22. The BOJ’s estimate of the output gap also remained negative at -0.1% of GDP in 3Q22.
- Japanese enterprises expected inflation to rise 2.7% in the next one year and 2.0% in the next five years, according to the 4Q22 Tankan survey. Households’ inflation expectations were even higher, at 10% and 5% for the next 1 and 5 years. In the financial markets, however, inflation breakeven remained at around 1% on the 1-5Y horizon.
- Total wages jumped by 4.8% YoY in Dec22, thanks to the bigger-than-usual winter bonuses to cover the rise in household living costs. But base wages continued to grow at a moderate pace of 1.8%, falling short of the 3% level sought by the BOJ to achieve a stable 2% price target. Labor unions at large companies have demanded bigger pay rises during the upcoming Shunto negotiations. But this may not reflect the wage situation among the majority of Japanese workforce – SMEs employ 60% of the total workforce; non-regular workers account for 30%.
Revising the 2% inflation commitment?
Without sufficient evidence about a stable 2% inflation, the BOJ would have to revise its inflation commitment to pave the way for policy normalisation. During a joint statement with the government released in 2013, the BOJ said that it will pursue monetary easing and aim to achieve the 2% price target “at the earliest possible time”. Furthermore, the BOJ reinforced its inflation commitment when introducing the Yield Curve Control in 2016, pledging to continue expanding the monetary base until the YoY increase in consumer prices “exceeds 2% and stays above the target in a stable manner”.
The BOJ may need to communicate with the government to revise the joint statement, removing the phase of “at the earliest possible time” and emphasizing that the 2% price target will be achieved over the medium- to long-term. It may also need to modify the inflation-overshooting commitment, e.g., introducing a more flexible inflation target with a range around 2%. An ambiguous inflation target, however, carries the risks of reducing policy transparency and undermining credibility.
A rapid yield rise and the adverse impacts
The major concerns about BOJ policy exit are a rapid rise in JPY yields, and the resultant adverse impacts on fiscal sustainability, financial stability, and the real economy:
- Public finance will deteriorate. The central government’s debt ratio rose sharply after the Covid pandemic, from 201% of GDP in 2019 to 230% in 2022. A 100bps rise in effective interest rates is estimated to increase the government’s annual debt repayment costs by JPY12tn (2% of GDP).
- The BOJ itself will incur significant losses. The BOJ’s bond holdings are currently equivalent to over 50% of the total outstanding JGBs, and its all assets are equivalent to 125% of GDP. A 1% yield rise will cause an unrealised loss worth JPY28.6tn on the BOJ’s bond holdings, according to the latest estimate by Deputy Governor Amamiya in December 2022.
- Another byproduct is FX volatility. The monetary policy divergence between the BOJ and other major central banks has sharply weakened the yen over the past one year. USD/JPY and 10Y UST-JGB yield spread exhibited a high correlation of 0.9 through Jan-Dec22. Rapidly rising JGB yields could lead to a notable rebound of the yen. On the other hand, fiscal sustainability concerns could hurt investor confidence on the yen and amplify the volatility in the FX market.
- Repercussions will also be felt by the real economy. A rapid yield rise will increase corporate and household financing costs and depress investment and consumption demand. Heightened FX volatility will add to business uncertainties. A possible pullback in the stock market would generate negative wealth effects and further dampen consumer and investor confidence.
What to expect ahead
In our view, relaxing YCC remains the most likely policy option at the March-April meetings. These include further widening the 10Y yield band by another 25bps to ±0.75%, and/or shifting the 0% target from 10Y to the shorter-dated 5Y yield. These measures will not require a policy overhaul and should not trigger a sharp yield increase. They may also help to further rectify the distortion of the yield curve and improve liquidity conditions in the JGB market. On the negative side, a gradual relaxation of YCC could fuel investor expectations for bigger policy changes; selling pressure in the bond market would continue.
In the longer term, the odds of a YCC exit are rising for the 2H23-2024 forecast period. The BOJ may eventually abandon the 10Y yield cap and shift to a conventional policy framework targeting at short-term interest rates. It would attempt to mitigate the potential impacts through forward guidance and operational details, such as continuing to pledge large-scale bond purchases for quite some time, and providing greater incentives for domestic financial institutions to buy JGBs. After abandoning YCC, the BOJ would then end the negative interest rate policy, raising the interest it pays on banks' excess reserves into the positive territory. Finally, it would start to unwind QQE and shrink the balance sheet at a managed and predictable pace. Considering the technical complications and the substantial market/economic implications, the whole process of policy exit will likely be a long and tough road requiring a slow and cautious approach ahead.
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