The Bank of Japan announced changes to its monetary policy strategy that will have little impact on current monetary conditions but are potentially significant for the medium term. Markets have reacted with relief that the BoJ rejected the option of cutting the policy rate deeper into negative territory, a move that would have raised further doubts about financial-system health.
The two key changes are: first, the abandonment of quantitative goals for JGB purchases and monetary base expansion in favour of a target, currently set at “around zero”, for the 10-year JGB yield; and secondly, a commitment to keep expanding the monetary base until consumer price inflation (as measured by the CPI excluding fresh food) overshoots the 2% target “in a stable manner”.
The shift to a yield level target set at zero will have little impact on current market conditions but suggests that policy will be more inflationary over the medium term. Under the previous strategy of QE targets, a rise in inflation would have been expected to be matched by a firming of JGB yields, keeping real yields broadly stable. The new peg at zero will force real yields lower as inflation picks up – policy, in other words, will become more expansionary as inflation rises towards the target, consistent with the BoJ’s new goal of achieving a sustained overshoot.
A yield level target also implies that the US-Japanese differential will be driven solely by Treasury yields. Stronger US growth and a hawkish Fed, therefore, should put more upward pressure on the US dollar / yen exchange rate than under the previous strategy.
Some commentary may interpret the changes as disappointing and evidence that the BoJ is running out of ammunition. The judgement here is that there was no need for another bazooka shot – strong monetary trends, improving global economic prospects and a tight labour market suggest a pick-up in growth and further progress in reviving inflation. The BoJ’s backpedalling on negative rates and implied commitment to falling real yields are positive developments for the equity market, which will continue to benefit from BoJ buying of ¥6 trillion per year, equivalent to 1.9% of TOPIX market cap.