The Bank of Japan switched the focus of its monetary policy last week by adopting a policy called “yield curve control” while leaving official interest rates unchanged at minus 0.1 per cent. This new emphasis is aimed at countering some of the unintended consequences of negative interest rates by alleviating pressure on banks’ profitability.
In theory this should allow the benefits of negative rates to work more effectively in the economy at large and thereby ultimately to boost inflation. In fact the BoJ said that it will continue to expand the monetary base until the 2 per cent inflation target is met and even overshot, and it will continue to buy Japanese government bonds (JGB) to keep 10-year yields around current levels of 0 per cent. Whether or not these measures will have the desired effect, however, remains uncertain, and is effectively another throw of the dice in the BoJ’s long-standing battle to pull Japan out of stagnation.
BoJ monetary policy easing has been one of the constants of the world economy over the past two decades, with only a brief and temporary period of tightening in the mid-2000s.
However, even after such a protracted period of monetary policy easing there has been little observable benefit from it. Inflation remains negligible, as does nominal GDP. And more recently since first introducing negative interest rates back in January, Japanese equities have halved and the Japanese yen has soared – hardly a ringing endorsement.
Negative interest rates in general act as a tax on banks and while the BoJ’s negative interest rates were structured in such a way to limit the effect on banks’ net interest margins, the damage was still felt.
The BoJ is therefore now responding by implicitly seeking to steepen the yield curve to provide the banks with some relief.
This approach of attempting to control the yield curve is a bit like the Federal Reserve’s Operation Twist in 2011-12, in which the Fed tried to manipulate the US yield curve and reduce 10-year Treasury yields. The aim was to bring about a broad easing in financial market conditions that would provide additional support for the economic recovery.
However, it is now a matter of debate whether the Fed’s various quantitative easing programmes have contributed much to the real economy, beyond the “counter-factual” of preventing things from getting worse.
But what if this latest attempt by the BoJ to steepen the yield curve does not make any difference either? After all, when the Fed ended Operation Twist and QE, US Treasury yields still continued to weaken. Attempts by central banks to control the operation and functioning of financial markets are notoriously fraught with risks, potentially creating bubbles and distortions in the financial system.
Japan’s targeting of a specific bond yield and its ownership already of 40 per cent of the JGB market makes these risks all the greater. Investors are becoming naturally concerned that the effective limits of monetary policy are being reached and the Bank for International Settlements has also voiced its own concerns recently that the financial markets have become too dependent on the actions of central banks.
To sustain a steeper yield curve really requires confidence that the Japanese economy is recovering and that inflation is rising, something that consumers and investors have to buy into.
After 20 years of numerous experiments it would not be surprising if the use of evermore creative monetary policy tools creates more uncertainty rather than confidence.
Fiscal policy errors such as raising the consumption tax inappropriate times have compounded the negative impact and the Japanese government has had to delay plans to increase it further.
Monetary policy and fiscal policy should ideally work hand in hand, not in the opposite directions. Of course, monetary policy was supposed to be only one of the three “arrows” of “Abenomics”, with fiscal policy and structural reforms the other two. Increasingly it has felt as if monetary policy is the only “arrow” being used.
The dollar-yen exchange rate is often regarded as the barometer of market faith in BoJ policy and the yen has been broadly steady in the aftermath of the latest announcements, suggesting a degree of caution about whether they will succeed. The question is how long will the Japanese authorities give these latest policies to work, and how long will markets be patient before drawing stronger conclusions?
Tim Fox is the chief economist and head of research at Emirates NBD