[Tokyo 26th]- Soon the name of the new governor of the Bank of Japan will be revealed. The normalization of monetary policy that person must undertake is likely to be an extremely bumpy road. Perhaps his five-year term will not be enough, and it may take more than ten years.
Therefore, I would like to consider the next focus, the abolition of the Yield Curve Control Policy (YCC). At the meetings held in December last year and January this year, I realized again how difficult it is to review the scheme. The Bank of Japan itself seems to be struggling.
First, at the December meeting last year, the upper limit of the fluctuation range of long-term interest rates was raised from 0.25% to 0.50%. Actually, it would have been nice to remove the upper limit, but that would have led to a jump in long-term interest rates. However, even after the upper limit is set at 0.50%, upward pressure on maturities such as 8 and 9 years will continue to work. Inevitably, there was no choice but to suppress upward pressure on interest rates in 2010 with a limit price operation.
At the January meeting, it will be decided to lengthen the fund-supplying operation against common collateral for up to 10 years as a hidden gem. The BOJ believed that the distortions in the yield curve would naturally be eliminated because financial institutions would buy bonds with higher interest rates using the funds they obtained from operations. This is how monetary policy has been conducted to date.
If it were to lengthen the operation against common collateral, financial institutions would buy long-term government bonds, so the BOJ would not have to purchase outright bonds. Yet the Bank of Japan’s balance sheet swells. If the limit price operation exceeds the upper limit set by the Bank of Japan, you have to buy as many long-term government bonds as you like. In that respect, the joint collateral operation can be stopped at any time. Offer long-term pooled collateral operations only when necessary. In terms of the ability to weaken control over long-term interest rates at any time, the January measures will loosen YCC’s ties to date.
However, as long as long-term interest rates continue to rise above the upper limit set by the Bank of Japan, long-term operations must continue. The Bank of Japan’s balance sheet continues to swell and long-term funds continue to flow. The Bank of Japan will be forced to continue its unintended quantitative easing. The only way to escape from the dilemma that the BOJ’s supply of funds increases as the inflation rate rises is to decide to abolish the YCC and stop controlling long-term interest rates.
When the decision was made to lengthen the pooled collateral operation, I suspected that it was a long-term operation used by the European Central Bank (ECB) as an easing tool. When the European and American central banks are tightening, I felt that it was really perverted that the Bank of Japan introduced the long-term operation that the ECB used instead.
So far, I have explained that the decisions made at the January meeting did not essentially resolve the dilemma of the BOJ’s control of long-term interest rates. If the Bank of Japan tries to flatten out the short-term distortion of YCC, it will have to increase the supply of funds.
The reason why the YCC abolition theory is emerging is that if we try to intervene in the rise of long-term interest rates in Japan amid global inflation, we will have to additionally strengthen easing. Many people think that they want to abandon that framework.
The second best course of action is to raise the upper limit of long-term interest rates beyond the level of natural long-term interest rates. Under current conditions, the 10-year cap will likely be raised to 1% or 1.5%.
However, if long-term interest rates rise to that extent, the government’s interest payments will increase. Corporate funding costs will also increase. In addition, the BOJ itself worries that if the 10-year upper limit is set at 1%, it will send the message that the BOJ is finally heading toward an exit. I absolutely do not want to be seen as if the Bank of Japan is inducing a rise in long-term interest rates.
I expect that the upper limit of long-term interest rates will be raised to 0.75% or even 1% under the next governor of the BOJ. This is because Japan’s inflation rate is likely to exceed 2% even in fiscal 2023. The background is that the natural long-term interest rate will continue to rise for some time.
If the BOJ allows long-term interest rate hikes, there is no doubt that political criticism of the BOJ will intensify. How the next president will explain this is a big issue.
At that time, the Bank of Japan must persuade YCC of its limitations. Under the Kuroda regime, YCC was decided on the assumption that long-term interest rates could be completely controlled.
However, what has become clear from the experience since 2016 is that once full-fledged upward pressure on long-term interest rates emerges, it will be difficult to control them completely. It will be difficult to raise the upper limit of long-term interest rates further unless Japanese society as a whole understands that it cannot be completely controlled. It is, so to speak, a paradigm change from the Kuroda regime.
The traditional understanding of monetary policy has been that interest rate manipulation moves the policy rate in line with the natural interest rate level. They are artificially accomodating to the market price. This artificiality is not about control, but only to the extent of delaying it a little or strengthening it a little. Furthermore, it is impossible to endure the upward pressure on rising interest rates over the long term. Markets are like that.
It is difficult to share this feeling with society as a whole. The government’s desire is for the Bank of Japan to make interest payments on government debt as low as possible. The Bank of Japan has implemented that policy under Governor Haruhiko Kuroda. And now it’s reaching its limit. It is the role of the next president to get that recognition.
The Bank of Japan tends to be unable to admit that once it has decided it was a mistake. The former governor’s policy can never be said to have been wrong. However, from April onwards, a course correction from the Kuroda route is practically inevitable. The job will be really tough for the next president.
Editing: Kazuhiko Tamaki
(This column isReuters Forex ForumIt was published in (Based on the author’s personal opinion)
* Hideo Kumano is chief economist at Dai-ichi Life Research Institute. Joined the Bank of Japan in 1990. He retired in July 2000 after working in the Research and Statistics Bureau and the Information Services Bureau. In August of the same year, he joined the Dai-ichi Life Research Institute. Incumbent since April 2011.
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