Ever since interest rates hit zero, central banks have been forced to use unconventional measures. This has usually taken the form of forward guidance plus asset purchases such that unconventional monetary policy has become conventional. However, earlier this summer, Bank of Japan governor Haruhiko Kuroda called for a “comprehensive assessment” of the bank’s monetary policy. The result was published yesterday.
The Key Points. The new framework consists of two parts, which the BoJ described in classic central bank-speak as an “inflation-overshooting commitment” and “yield curve control”. In plain English, the BoJ will not just aim to hit its 2% inflation target but exceed it and it will control not only short rates but also long rates. Both are bold moves.
The practical implications are: 1) the BoJ’s short-term policy rate is unchanged at minus 0.1%; 2) the BoJ will aim to keep the 10yr JGB yield around zero; 3) it thinks that this implies JGB purchases of “more or less” ¥80trn a year, close to the present pace; 4) it will continue this policy until inflation “stays above the target in a stable manner”; 5) it will reduce purchases of longer-dated JGBs beyond 10yr maturities (to help banks); and 6) it will amend its ETF purchases (to correct the Nikkei versus Topix distortion).
Deliberately Irresponsible Policy. The inflation over-shooting part of the new policy follows work by US academics. Michael Woodford of Columbia University presented a persuasive paper at the Jackson Hole conference in 2012, arguing that unconventional policies would only work if the general public thought the central bank was being reckless. Paul Krugman has endorsed the idea. The BoJ is the first central bank brave enough (or desperate enough) to see whether Woodford is right.
Quantitative Easing Revisited. In our view, QE has three problems. First, the bank does not know how much to do (because the precise impact is unknown); second, there are unintended consequences; and, third, it may be difficult to unwind.
The new BoJ policy addresses the first point directly. Central banks usually measure the impact of asset purchases in terms of how far bond yields fall. The BoJ is reversing the logic in targeting the 10yr JGB yield and saying it will buy enough bonds to achieve this. Policy should be more precise.
In the process, it mitigates the second problem in that the collateral damage of asset price inflation will be limited. Unfortunately, it does little to deal with the third but, given the rapid expansion of the BoJ balance sheet (see chart), better control of JGB purchases will be welcome.
Conclusion. There will be no need to forecast Japanese interest rates in future: they will be roughly zero out to ten year maturities. The market reaction of higher equity prices and a stronger yen was probably about right and may continue. And will the BoJ achieve 2% inflation? Well, it has given itself a fighting chance.
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