BoJ Exit Strategy from Ultra Loose Monetary Policy

BoJ Exit Strategy from Ultra Loose Monetary Policy

The new BoJ Governor Ueda stated on 9 May that “we would like to end YCC & proceed to shrink the balance sheet once we have an inflation outlook indicating that sustainable & stable 2% inflation will be achieved.”?Taking this action would constitute an end to the so-called ‘ultra-loose’ monetary policy.?It would not constitute restrictive monetary policy, as real rates remain decidedly negative in Japan, but it would end the dimension of monetary policy causing the worst externalities, namely, a dysfunctional JGB market and extreme Yen weakness.?How and when should the BoJ do this?

The guidance given by Gov Ueda following the 27-28 Apr MPM suggest two preconditions: confidence in the inflation trend projections, and positive balance of risks.?To now begin defining the existing 2% inflation target as a ‘trend’ seems an egregious dereliction of duty for an inflation-targeting central bank, but nevertheless, Kuroda’s ‘persistently’ and Ueda’s ‘patiently’ now appear to be defined as a 3-year CPI forecast above 2%.?The next BoJ Outlook Report is not due until 28 July, so this appears to materially shift the timing of a proposed end to YCC.?Given the tankan survey 5-year inflation projections rose above 2% for the first time, momentum does appear to be building for the BoJ to raise its long-term inflation forecast to 2%, paving the way for an end to ultra-loose monetary policy.?Simultaneously to this, the announced BoJ historical policy review, which is projected to take much longer than the previous one in 2016, is likely to focus instead on modifying the language and guidance that currently defines the BoJ’s price stability regime.?Whether the new regime will retain a joint agreement with the government remains to be seen.

The decision in 2013 by the Bank of Japan to change its definition and terminology for price stability was aimed at convincing market agents that it would pursue its policy objectives in a one-pointed way until achieved, as opposed to simply pushing a policy bias in the direction of its medium-term goal.?It was hoped that greater market confidence in the Bank’s commitment to meet the “target” would alter economic assumptions and inflation expectations.??The more specific statistical “target” definition was thus adopted as stated below.

January 22, 2013 Bank of Japan

The "Price Stability Target" under the Framework for the Conduct of Monetary Policy

(3)?The newly-introduced "price stability target" is the inflation rate that the Bank judges to be consistent with price stability on a sustainable basis. The Bank recognizes that the inflation rate consistent with price stability on a sustainable basis will rise as efforts by a wide range of entities toward strengthening competitiveness and growth potential of Japan's economy make progress. Based on this recognition, the Bank sets the "price stability target" at 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) -- a main price index.

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Given this explicit statistical definition, there is no question that the “price stability target” has been hit. Year-on-year rate of CPI is 4.1%, with April marking 12 continuous months above target, and core-CPI showing a continuously rising trend.?So, what justifies the BoJ’s refusal to acknowledge that it has hit its target?

(4)?" Previously, the "price stability goal in the medium to long term" was in a positive range of 2 percent or lower in terms of the year-on-year rate of change in the CPI and the Bank set a goal at 1 percent for the time being. This time, replacing a "goal" with a "target" and setting that target at 2 percent in terms of the year-on-year rate of change in the CPI are based on the following recognition.

The Bank recognizes that the inflation rate consistent with price stability on a sustainable basis will rise as efforts by a wide range of entities toward strengthening competitiveness and growth potential of Japan's economy make progress. Today's expected rate of inflation has been shaped over the years. As the strengthening of growth potential makes progress going forward, the actual rate of inflation would gradually rise and accordingly the expected inflation rate of households and firms is likely to rise as well. Going forward, as prices are expected to rise moderately, it is judged appropriate to clearly indicate the target of 2 percent in order to anchor the sustainable rate of inflation.

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This concept of a rising inflation rate consistent with price stability for Japan, commensurate with its (hoped for) increase in potential growth rate, was aspirational at the time it was articulated and was considered to be the eventual fruit of PM Abe’s ‘Three Arrows’ economic policy coordination.?This justified the upward shift in its inflation target from 1-2% to 2%.?In the end, however, we did not reach the sustained 2% inflation target through increases in potential growth GDP, but rather external shocks such as China-US global supply chain split, Covid lockdowns, and Russia-Ukraine war.?An inflation target is not meant to incapsulate a prerequisite set of optimal macroeconomic fundamentals.?An inflation target is the speed limit you are allowed to travel amid ALL economic circumstances.?One would have expected the BoJ to learn from the errors of its G10 Central Bank peers, where nearly all made the mistake of labelling inflation in early 2022 as transitory and therefore not requiring immediate policy recalibration.?Like the BoJ, most were also giving forward guidance that an overshoot would be tolerated.?In Japan’s case, a 12-month overshoot before a post-Covid-opening of the economy even closes the output gap surely goes beyond what former Gov Kuroda originally intended in his 2016 pledge to tolerate an inflation target overshoot. The reality is, Japan will not be able to fully achieve its ‘Three Arrow’ objectives within one monetary easing phase.?Like other G10 countries, its Central Bank must comply with its own CPI-targeting regime or stand to lose the credibility that inflation targeting is meant to enshrine.

Knowing how dynamic the global economy and geopolitical risks are, any reasonable policymaker can conclude without a study that aggressive policy settings from 10 years ago are unlikely to match current economic circumstances.?Given how exceptional these past 10 years have been in terms of global economic regime change, policymakers should welcome a recalibration, not resist it.

How can newly appointed Gov Ueda restore Japan’s secure footing as a global reserve currency country and a central bank that practices sound money??The first step is to shift back to being truly data dependent, like other G10 central banks have done.?Poor inflation forecasts and intellectual hubris led many policymakers to trust their own judgement over the clear implications of the data last year.?Japan has one of the most difficult inflation environments to forecast of all G10 countries, why would Ueda want to take the risk now to place such weight on the Bank’s 3-year inflation forecast??The MPB did not forecast any of the inflation outcomes for the past 3 years, why ask the market to trust such a conceptual construct now??If the BoJ simply scored the current inflation environment right now, as it is, they would easily conclude their target met:

Inflation Target Met

·?????Current core core CPI = 4.1%

·?????CPI trend & momentum = 12 consecutive months above target, Core on consistently rising trend, MPB forecasts for FY23 core-CPI raised 0.2% since January meeting

·?????Wage growth = shunto round 3.67%, Nikkei survey 3.89% (highest in 31 years), SMEs 3.57%, percentage of companies raising wages 62% (MoF survey)

·?????Tankan survey LT (5 years) inflation expectations above 2%

·?????Gov energy subsidies expire in Sep

The second prerequisite relates to assessment of balance of risks.?This phrase can be balance of risks to MPB forecast outlook for growth & inflation, or balance of risks posed by market externalities associated with YCC framework, -3.5% real 10Y bond yields, 225% debt/GDP, or the potential for unforeseen external shocks.?In the case of risks to MPB forecasts, the most recent Outlook report flags the view that risks are to the downside for growth forecasts in 2023 and balanced thereafter, even though OECD & IMF forecasts for Japan to be the one developed economy improving over 2022, and Japan being the last to fully open after Covid lockdowns.?Whether this view of risks embeds the end of ultra-loose monetary policy or not, is anybody’s guess, but for sure, Japan will have the easiest financial conditions in 2023 of all the G10.?Does it really make sense to have downside risks to growth for 2023 and then balanced thereafter??On inflation, it’s the opposite.?MPB members view risks to inflation for 2023 forecasts to be to the upside, while risks are skewed to the downside for 2025, conveniently jumping over 2024, despite 2024 inflation forecasts already being revised upward by 0.2% since January.?I think it is safe to say that if you have upside risk to your 2023 & 24 inflation forecasts and your starting point is 2% above target, putting your risk management hat on, you normalise policy now and put yourself in a stronger position to cope with unforeseen shocks in the more difficult forecast horizon of three years out.

As for the market and credibility risks, I don’t think many in the market would agree with Ueda’s assessment expressed after the last MPM that side effects do not outweigh the benefits of YCC & QQE, and that it is a greater policy risk to tighten before reaching the target (his revised conceptual definition of target) than to be late and experience further deterioration of inflation credibility.?One need only look at the Fed’s experience.?So many years of inflation credibility lost in just a few quarters, as Chairman Powell had to scramble to recover from the ‘transitory’ debacle, not to mention the regional bank crisis triggered by unexpected, swift FFs rate hikes.?An inverted yield curve and dismissal of Fed SEP forecasts is the new normal.?

The costs to Japan would be much greater, as its YCC framework requires it to continue monetising debt at an extraordinary rate, its REER trades at 40-year lows, the BoJ had to spend over $40bn to defend its currency last year and we are currently just 5% away from the last intervention level. ?And of course, the ultimate penalty for loss of credibility, a sovereign credit downgrade.?Foreign investors already hold the majority of their Japan debt in T-bills, due to risks in the bond market.?The lack of free float in some of JGBs has led to delisting from global bond indexes.?A deep, liquid, freely trading sovereign bond market is a fundamental component of being a reserve currency, a major economy, a global power.?It would seem to me the stakes are much higher than the balance of risk assessment articulated by Ueda.

So, what would be a logical path for ending ultra-loose monetary policy??The June MPM should see a continued shift in Summary of Opinions.?In the April report, 6 out of 8 comments on growth were positive, 4/8 concerned on price levels, and only 3/12 suggested it might be time for monetary policy change.?A significant increase in net assessments for change should be evident in June Summary of Opinions.?Further deterioration in the May Bond Market Survey (if that is even possible) should be evident.?No announcement on snap election from PM Kishida before the end of the current parliamentary session ends.?The month of June playing out like this, along with record summer bonuses gracing the newspaper headlines, would set up July MPM as the likely event for announcing an end to YCC, and perhaps a decision on selling ETFs, REITs and/or ending purchase of corporate debt securities.?

The end to YCC should be much easier than many fear, as the BoJ can simultaneously announce a commitment to bond buying operations aimed at smoothing to ensure the market settles down quickly from the shock.?Furthermore, Life Insurance cos., and other long duration buyers, have made it clear they intend to increase allocations to JGBs in FY2023 . . . after the BoJ ends YCC.?The fair value level often cited is 0.80% for 10Ys, so it is unlikely the BoJ would have to do much beyond that level.?Other technical measures, such as increasing collateral available for various tenors chronically scarce in the repo market would also improve market liquidity.

Expected Monetary Policy Meeting Window for eliminating YCC

[~ 16 June ?to ?22 Sep ~]

·?????May Bond Market Survey 1 Jun

·?????BoJ MPM 16 Jun

·?????Current parliament session ends 21 Jun

·?????BoJ Summary of Opinions 26 Jun

·?????BoJ MPM 28 Jul (Outlook Report)

·?????BoJ MPM 22 Sep

·?????Gov subsidies on energy prices end Sep

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This represents my updated view on timing and factors at play for the timing of an end to YCC & QQE.?One can’t be too influenced by the seemingly clear push back from Ueda on an early adjustment to YCC.?The BoJ will be walking a fine line between communication with the market and fuelling speculation, particularly when Parliament is perhaps the most important audience.?Furthermore, the February-April period marked the most optimistic period for hopes that the Fed would conclude its rate hikes early, and rate cuts would be on the cards by end of the year.?The BoJ has seen that inflation in Japan, albeit significantly lower, has tracked the trends globally.?Therefore, as expectations of higher for longer take hold overseas, then expectation for core-CPI falling below 2% in FY2H-23 will be revised out of MPB forecasts.?The MPB members may be more data dependent on the US than their own economy.?

Charts of ‘side effects’ of YCC & QQE