Although the Bank of Japan has enjoyed some success with its novel approach to financial engineering – including implementing negative interest rates and yield-curve controls – the economy and inflation both need to improve. As a result, we expect the BoJ to keep its monetary policy on hold, at least for now.
We do not expect any change in policy from the Bank of Japan (BoJ) at its upcoming monetary policy meeting. As a result, key elements should remain same:
- the short-term rate should stay at -0.1 per cent;
- the yield target for 10-year Japanese government bonds (JGBs) should remain at around 0.0 per cent ; and
- exchange-traded fund purchases should continue at JPY 6 trillion per year.
The BoJ sees a healthy economy
Japan’s economy remains on a steady growth trajectory, as confirmed by second-quarter gross domestic product growth coming in at an annualized 2.5 per cent quarter-over-quarter. The BoJ expects this to continue, and believes the economy could even surpass the potential growth rate of around 1.0 per cent.
The BoJ has already upgraded its assessment of the economy as one that will “continue expanding” given several key factors: growth is above-potential, labour-market indicators continue to tighten, and both fiscal and monetary policy remain accommodative.
Not all is well with wage growth
Due to Japan’s tradition of lifetime employment, wage growth still lacks momentum despite an unemployment rate that was at 2.8 per cent in July – lower than the roughly 3 per cent figure that the BoJ sees as Japan’s structural unemployment rate. Moreover, the ratio of job openings to applicants remains at a 43-year high. However, the Phillips curve relationship between the output gap and underlying price trends still points to latent upward pressure on wages and a moderate rise in core prices.
Inflation is far from the BoJ’s 2 per cent target
The presence of lacklustre inflation despite a tight labour market raises the question of whether the BoJ will be able to achieve its aim of raising the consumer price index until it reaches its 2 per cent price stability target. The BoJ is attempting to use yield-curve controls to maximize the positive effects of two key factors on the real economy: (1) the fall in real interest rates and (2) the likely boost to inflation expectations from its “inflation-overshooting commitment”.
Yet the BoJ’s observation that inflation momentum is being maintained is based on continuing improvement in the output gap and on a projected rise in mid-/long-term inflation expectations. But even with firm growth, inflation remains far from the BoJ’s target, and it may take longer than expected to get there.
Adding to our expectation that the BoJ won’t announce changes to its policy are the public’s concerns about the side effects of aggressive easing. Moreover, two new policy board members have come on board, so there is little likelihood of tapering or even tightening in the near future.
Despite some struggles, the BoJ should stay the course
If upward pressure on Japan’s long-term yields strengthens on the back of higher US rates, it will become more difficult for the BoJ to maintain its policy of yield-curve control. This could force a greater expansion of the BoJ’s balance sheet and weaken the Japanese yen.
Because fundamentals surrounding the domestic economy and inflation need to improve further, we believe the BoJ is likely to stay on hold for the time being. If the Federal Reserve and the European Central Bank continue on their paths toward policy normalization, it could act as a buffer against any increase in appreciation pressures on the yen due to a narrowing of the interest-rate spread.
However, the BoJ is trying to control the yield curve while decreasing the amount of JGBs it buys. As a result, while it is possible that we may see tapering of JGB purchases going forward, we do not expect to see a complete end to this program – let alone balance-sheet reduction.