For nearly two decades, the Bank of Japan (BoJ) has deployed negative interest rates, asset purchases and other unorthodox monetary policy tools to battle moribund inflation. Today, that policy toolkit is showing signs of exhaustion – a warning to central banks which have followed Japan’s policy lead.
In its much-anticipated July 2018 meeting, the BoJ widened its upper bound for the yield on the 10-year Japanese Government Bond (JGB) to 20 basis points (bps), or 20 hundredths of 1%, from 10 bps. Subsequently, BoJ officials suggested the band could be widened beyond the 20 bps. The BoJ also cut in half the amount of bank reserves subject to a negative rate of -0.1%.
Both moves appear to be steps toward policy normalization. However, the central bank also stated short- and long-term interest rates would remain at extremely low levels for an “extended period of time.” In other words, the BoJ issued clearly dovish forward guidance on the heels of tightening policy steps. This self-contradictory behavior stems from a dilemma: a weakening macro-economic outlook, which would require more policy easing, and the negative impact of further accommodation on the financial sector. Thus BoJ monetary policy appears to have reached the limit of effectiveness.
Despite almost two decades of unconventional monetary policy, Japan’s growth and inflation outlooks are both dimming. The BoJ has lowered its near-term growth outlook to 1.5% for 2018 from 1.6%, likely as a result of the negative 1Q2018 GDP print. Inflation remains well below the central bank’s 2% target, and the BoJ has again revised down its core inflation outlook to 1.6% in 2020 from 1.8%.
This downgrade would traditionally cause the BoJ to ease monetary policy further to boost the long-run outlook for inflation to its target. However, excessively loose monetary policy has increased financial stability concerns. A study by Japan’s Financial Services Agency (FSA) concluded that the combination of shrinking population and negative interest rates has likely led to over half of the country’s 106 regional banks losing money on their core lending and fees business in 2017. Regional banks hold about half of Japan’s $4 trillion in outstanding debt. The BoJ is now under pressure to restore bank profitability. This implies a move to a more restrictive monetary policy, including higher interest rates.
The BoJ is stuck between the need to simultaneously ease and tighten monetary policy, as the macro outlook is in conflict with the financial stability outlook. If the BoJ tightens policy to support the regional banks, it will be tightening domestic financial conditions in the face of a weaker growth and inflation outlook. This will only add further headwinds to the slowing narrative. Moreover, allowing yields to back up meaningfully will aggravate the interest expense for the government — a burden which already represents about 30% of the overall budget.
The practical effect of the BoJ’s unconventional policies has been to fix the JGB yield curve. This has resulted in the currency being the adjustment mechanism for the economy. Allowing the yield curve to steepen by a significant amount would be seen as a hawkish tilt to monetary policy, resulting in currency appreciation. A stronger yen would put downward pressure on prices, especially in an import-dependent economy such as Japan. The BoJ conveniently watches less import-sensitive inflation measures, but a strong yen would eventually have second and third order impacts on prices and must be watched closely by the bank. To date, exports still appear to be brisk in the face of recent yen appreciation. Continued appreciation, however, will eventually undermine competitiveness of Japanese-produced goods, risking a headwind to wages as companies need to cut costs to protect margins.
It is also important to note that in the event of an external shock, the BoJ would likely be unable to stop interest rates from falling as local investors buy JGBs as a flight-to-safety trade. The method available to arrest a yield decline is for the BoJ to sell JGBs, which implies a tightening of policy. Combined with repatriation flows, central bank selling of JGBs would likely drive up the yen, which would create greater macroeconomic headwinds.
Clearly, the BoJ is stuck in a very difficult position. The only way out of the current dilemma is for a sustained period of above-trend growth and inflation. Given the BoJ’s most recent economic projections, reflation appears unlikely in the near future. Meanwhile, monetary policy is hurting the outlook for the domestic regional banks. It appears that the BoJ has taken unconventional monetary policy to its limit. The central bank faces a situation where it can neither address the macroeconomic outlook nor unwind the negative impacts of its current policy setting. It is unclear what policy levers will be at the BoJ’s disposal in the next downturn.
The Bank of Japan has engaged in unconventional monetary policy much longer than the other developed market central banks, having introduced a “zero interest rate policy” in February 1999. After the 2008 global financial crisis, the U.S. Federal Reserve, European Central Bank and the Bank of England all engaged in unconventional monetary policies to reduce effective interest rates below zero. Today, these policies are now considered part of the monetary policy tool kit available to central banks. The depletion of the Bank of Japan’s policy toolkit stands as a cautionary case study for the world’s central banks.