Bank of Japan's introduction of yield curve control could lift expectations, but inflation target still daunting

The Bank of Japan (BoJ) introduced yield curve control as an additional policy measure at its monetary policy meeting held on 20 and 21 September. The BoJ named yield curve control as a primary measure for market operations, and it will attempt to keep the yield on 10-year Japanese government bonds (JGBs) at around its current level (zero) by purchasing bonds while leaving its negative interest rate policy intact (keeping the short-term interest rate below zero). Despite this addition, the BoJ retained quantitative and qualitative monetary easing (QQE) with a negative interest rate. The central bank kept a negative interest rate of -0.1% for policy-rate balances in current accounts held at the bank by financial institutions. The bank also maintained purchases of JGBs in line with the current pace to increase the amount of outstanding JGBs held at about JPY80 trillion (USD780 billion), while also maintaining its purchases of exchange-traded funds (ETFs), real estate investment trusts (J-REITs), commercial paper (CP), and corporate bonds.

The bank said additional monetary easing will seek to: lower short-term interest rates; lower long-term interest rates; increase asset purchasing; and accelerate expansion of the monetary base, if necessary. The bank will continue QQE with a negative interest rate and yield curve control until the consumer price index exceeds its target of 2% in a stable manner.

While the BoJ maintained its assessment of the current situation and the outlook for economic activity and prices, the decision to introduce the new framework was based on its comprehensive assessment of developments in economic activity and prices, as well as policy effects since its introduction of QQE and QQE with a negative interest rate. The BoJ decided that QQE could successfully end deflation as it is defined as a sustained decline of prices. However, it said the reasons Japan has been unable to reach the bank's inflation target of 2% were: declines in oil prices; weak demand following the consumption tax increase in April 2014; and the slowdown of emerging market economies, as well as volatile global financial markets. These factors weighted on inflationary expectations. In order to increase inflationary expectations, the BoJ believes one of its more important roles is to provide a long-term commitment to asset purchases aimed at expanding the monetary base. At the same time, the bank concluded that combining these measures with a negative interest rate would be effective to lower the yield curve.

Outlook and implications

The BoJ's new framework makes it clear that the direction of its future decision-making is to prioritise measures that could boost forward-looking expectations and reduce uncertainties over policy. The framework to introduce yield curve control was surprising, but raising longer-term interest rates was in line with what market participants expected given that the 10-year JGB yield has steepened over the last month or so. Yield curve control is expected to create inflationary expectations for the long term, as well as help financial institutions' asset allocation and reduce downside from the negative interest rate policy. The market initially reacted with a rally in equity prices and the yen softened to over JPY102/USD1. While the BoJ decided to leave unchanged its asset purchasing at this point, the new framework could allow it to reduce bond purchases, once inflationary expectations rise.

IHS Markit expects the negative interest rate and asset purchases to remain at their current level over the near term, given that the second-quarter GDP figures showed positive growth and some indicators that suggest that external demand has bottomed out, while excessive uncertainties over negative impacts from the United Kingdom's decision to leave the European Union have eased. However, as the BoJ pointed out, a further rise in inflation expectations through the adaptive mechanism is uncertain and may take time. It is also uncertain whether the new measure can control yield curve as anticipated, although the BoJ will introduce new operations to prevent the yield curve from deviating substantially from the current levels. The BoJ still needs to purchase large amounts of JGBs, and continuity remains questionable. Moreover, acceleration of structural reforms and deregulation are also important keys for filling output gaps and increasing prices.