The appreciation of the yen against the US dollar had progressed since the 2008 Lehman Shock and had reached below 80 yen per the US dollar after the March 2011 East Japan Earth Quake, amplifying deflation. Under these very difficult economic conditions, Mr, Shinzo Abe obtained a landslide victory at the general election and become prime minister in late 2012. Under his prime ministership, the government and the Bank of Japan (BOJ) jointly announced a 2% price stability target in the following month and the BOJ promised to achieve the target as soon as possible.
In line with this new target, Mr. Haruhiko Kuroda became BOJ governor and served two terms to implement unprecedented level of monetary easing for 10 years starting from April 2013. Reflecting market expectations that massive monetary easing would be implemented in the near future, the yen began to depreciate and stock prices began to rise sharply from late 2012. Over the past 10 years, the ratio of BOJ’s assets to nominal GDP surged from about 30% to 134%. The BOJ currently holds about a half of outstanding Japanese government bonds (JGBs). Nevertheless, the average rate of economic growth achieved just 0.5% while the average rate of inflation recorded mere 0.3% well below 2% over the same period. BOJ’s core inflation and global standard core inflation also achieved just 0.8% and 0.3%, respectively. BOJ’s monetary easing experiment clearly failed in achieving the 2% price stability target. The overall effects of monetary easing have been viewed mixed in Japan. This reflects that higher profits for manufacturing companies and an increase in the number of foreign tourists have been achieved thanks to the depreciation of the yen while concerns over market distortions and monetization of fiscal deficits (given the ratio of public debt to nominal GDP reaching 260%) have been growing among market participants and experts.
Essence of the 10-Year Monetary Easing Experiment
Governor Kuroda’s monetary easing framework was called “Quantitative and Qualitative Monetary Easing” (QQE) and since 2016 called “QQE with Yield Curve Control [YCC]). QQE was essentially a monetary base control by setting the annual pace of the monetary base increase—60~70 trillion yen initially (about 12-14% of nominal GDP) and further expanding to 80 trillion yen (15% of nominal GDP) from late 2014. The “quantity” referred to the monetary base control while the “quality” referred to a lengthening of the JGBs purchased and an increase in purchases of stock exchange-traded funds (ETFs) and real estate investment trusts (J-REIT). The monetary base target was achieved mainly by purchasing JGBs massively all up to the 40-year maximum maturity. The forward guidance on QQE (with YCC since 2016) was also introduced from the beginning, which stated that the current monetary easing would continue as long as necessary for maintaining the 2% price stability target in a stable manner.
Year 2016 Became a Turning Point of the Monetary Easing
The QQE framework reached a turning point in January 2016 when the BOJ announced that a negative 0.1% interest rate would be applied to part of excess reserves in the following month. The announcement brought a great surprise to the public and markets since the BOJ had repeatedly denied the policy tool for many years and Governor Kuroda did so about two weeks before the January 2016 monetary policy meeting. It appears that the negative rate policy was adopted out of concerns over some movements toward the appreciation of the yen and greater uncertainty arising from China’s stock market clash and banking sector problems in Europe. The decision may also have been inspired by the European Central Bank’ (ECB)’s adoption of the similar policy since mid-2014, which had contributed to the depreciation of the euro. However, the negative interest rate resulted in not only reducing Japanese banks’ already low interest rate margins, but also made it even more difficult to continue large-scale JGB purchases since banks had to pay interest on reserve balances that would increase after the sales of JGBs to the BOJ. Moreover, two other things happened beyond BOJ’s expectation. One was a sharp fall in long-term yields such as 10-year yield into the negative territory (around -0.25%), thus amplifying concerns among institutional investors over lower returns. Another was a sharp appreciation of the yen contrary to ECB’s experience.
The BOJ made a fundamental change to its QQE in September 2016 by adopting yield curve control (YCC)—setting a 10-year yield target at around 0% together with the already introduced negative interest rate. This represented the official abandonment of monetary base control as the BOJ stressed that negative interest rate and the 10-year yield have now become its main tools for further monetary easing. To facilitate YCC, two market operations were introduced newly: fixed-rate outright JGB purchase operations to maintain the 10-year yield at around 0% and fixed-rate funds-supplying operations for up to 10 years (extending the maturity from one year). Market participants widely viewed the YCC adoption as an action to correct the negative 10-year yield. The YCC did not bring any significant impact on the depreciation of the yen and higher stock price movements. Only after Donald Trump’s surprise victory in the November 2016 US presidential election and resultant higher long-term yields in the United States, market participants began to pay attention to interest rate differentials, thus depreciating the yen and raising Japanese stock prices.
BOJ’s communication strategies have become complicated since 2016 for several reasons. First, together with the adoption of YCC, the BOJ added the second forward guidance—an inflation-overshooting commitment. This is a commitment to expanding the monetary base until the rate of core inflation (excluding fresh food) exceeds the 2% price stability target and stays above the target in a stable manner. This new commitment may not be consistent with the YCC. Indeed, the monetary base dropped several times since then and especially in 2022. Second, the BOJ stated at the time of YCC adoption that an annual pace of JGB purchases of about ¥80 trillion would be maintained in the future. This promise, however, was not kept since the annual pace of purchases began to drop steadily from the following month. Third, the BOJ has reduced the impact of the negative interest rate on banks over time by reducing the portion of the excess reserves which are subject to the negative rate. This was done by offering zero or positive interest rate on excess reserves when providing long-term funds-supplying operations.
From 2018, the BOJ introduced flexibility to the YCC framework in three stages: first by explicitly adopting the yield target range of 0.2% in 2018, and then expanding it to 0.25% in 2021 and to 0.5% last December. The first two stages were implemented smoothly because of limited upward pressures on the 10-year yield. However, the third stage, which was implemented specifically to correct market distortions, created surprise to markets since Governor Kuroda denied the policy change a few months before the decision. Market distortions referred to the state in which the 10-year yield fell below the yields with remaining maturities of 8 or 9 years, as well as the declined degree of functioning in the bond market centered around 10-year yield as a result of BOJ’s disproportionately large intervention. These distortions became prevalent since April 2022 when the BOJ decided to contain upward pressures—arising from the United States and Europe conducting monetary tightening—by implementing the fixed rate outright JGB purchase operations to defend the 0.25% 10-year yield ceiling every working day as long as necessary.
To sustain the YCC, the BOJ added two other measures in 2023. One was the 5-year term (possibly up to 10-year) variable rate method of fund-supplying operations introduced last January. It aims to provide a definite profit margin to banks which borrow from the BOJ at slightly above 0.1% for 5 years and invest in high-yielding 5-year or longer-term JGBs. By exerting downward pressures on around 5-year yields, this may help to correct JGB yield distortions where 10-year yield remain below shorter-term yields. Another measure was to increase the cost of short-selling speculative transactions using 10-year bonds by making it more expensive for market participants to borrow such bonds from the BOJ. So far, the distortions remain despite these measures.
Meanwhile, frequent use of such measures may amplify side effects—such as locking in the BOJ’s balance sheets, complicating policy frameworks further, deteriorating liquidity and functions of the JGB markets, and distorting interest rate swap and other markets.
The Road Ahead under New Governor
Mr. Kazuo Ueda already expressed that YCC‘s benefits have exceeded its adverse effects and thus YCC will be maintained until the price trends improve significantly to form the prospect of achieving 2% inflation stably under his governorship. Mr. Ueda also made it clear that current higher inflation (3.3% in February 2023) has been driven by supply-side factors. Until generating domestic demand-driven inflation toward 2%, the current monetary easing is likely to be maintained.
At the same time, Mr. Ueda repeated that he will monitor adverse impacts of YCC on bond markets and will take additional offsetting measures to mitigate them in case it takes longer than expected to reach 2% inflation stably. Such remarks were welcome by market participants and the media who call for the normalization of the YCC—including the expansion of the 10-year yield to 0.5% or 1%, shortening of the maturity from 10 years to 5 years, and the abandonment of the 10-year yield control. Since mid-March 2023, market pressures on the 10-year yield turned upward to downward, lowering the 10-year yield well below the 0.5% ceiling. The recent financial stability concerns in the United States and Europe are likely to further strengthen the BOJ’s decision to maintain the status quo. Any upward adjustments on yields will generate valuation losses for Japanese regional banks, which may deter them from lending to small and medium-sized enterprises and negatively affect the Japanese economy.
What conditions enable the BOJ to exit from the YCC framework? Doing so before the 2% target is not in sight will be challenging for the BOJ. There is a risk that the BOJ’ credibility will be undermined if it pushes for unwinding monetary easing and then ends up making more adjustments to restore more monetary easing in the future. Mr. Ueda already pointed out that the BOJ made such mistakes by rushing to raise rates prematurely when it lifted the zero-interest rate policy in 2000, followed by the quantitative easing in 2006. He may be afraid of making a third mistake. Market participants and the media count on higher wage growth and resultant greater domestic demand. Nominal wage growth of around 3% is feasible in 2023 thanks to companies’ willingness to pay higher wages and the government hopes sustainable wage growth of around 2% thereafter—the highest level seen in the past 25 years. It is not clear continuous wage growth and demand-driven inflation will be materialized given corporate profitability remains low in terms of returns on equity (ROE) and assets (ROA) and that one third of population aged equal or over 65 years old are highly sensitive to price hikes due to limited pension benefits.
In order to promote the flexibility, one possible option could be to adopt a price stability target range that includes 2%. For example, a range of 1%-3% or 0.5%-2.5% might enable the BOJ to strengthen the framework’s flexibility while avoiding contradictions. Indeed, inflation may be more volatile and higher than it was before the Covid-19 pandemic—due to Japan’s labor shortages, rising production costs in China, intensified geopolitical risks and decentralization of production, and climate change. An inflation target range may be more suitable for the current inflation structure in Japan. In any case, there is no easy solution and it remains to be seen whether the BOJ will choose to maintain the status quo or normalize monetary policy.