Japan’s central bank made an announcement on Friday that has caused a stir in financial markets. The Bank of Japan (BOJ) has decided to loosen its yield curve control, raising concerns about the implications of continued monetary easing on both financial markets and the real economy. In its policy statement, the BOJ stated that it will allow 10-year Japanese government bond yields to fluctuate within a range of approximately plus and minus 0.5 percentage points from its 0% target level. However, it also stated that it will purchase 10-year JGBs at a fixed rate of 1% through its operations. This move effectively expands the BOJ’s tolerance by an additional 50 basis points.
The BOJ also pledged to conduct yield curve control with greater flexibility, viewing the upper and lower bounds of the range as references rather than rigid limits in its market operations. This decision was driven by the need to remain adaptable in the face of significant uncertainties surrounding Japan’s economic activity and prices. This marks BOJ Governor Kazuo Ueda’s first major policy change since assuming his role in April this year. The central bank also maintained its ultra-loose interest rate of -0.1% after its July policy meeting and revised its median inflation forecast for fiscal 2023 to 2.5%, up from the April prediction of 1.8%.
This new “flexibility” language used by the BOJ is reminiscent of the late 2022 policy, when the 10-year JGB target range was expanded from +/-25bp to +/-50bp. According to Stephen Halmarick, the Chief Economist at Commonwealth Bank of Australia, this flexibility does represent a tightening in monetary policy to some extent.
Years of accommodative monetary policy in Japan have resulted in carry trades heavily relying on the Japanese yen. Carry trades involve borrowing at low interest rates to invest in other assets that promise higher returns. The announcement from the BOJ triggered a sell-off, causing yields for the 10-year JGB to reach their highest level since September 2014. Additionally, the yen strengthened against the dollar.
Following its July meeting, the BOJ stated that it still needs to continue with monetary easing under Quantitative and Qualitative Monetary Easing with Yield Curve Control to achieve its price stability target of 2% in a sustainable and stable manner. Despite inflation consistently surpassing the 2% target for 15 consecutive months and some signs of wage increases, achieving the target remains elusive.
Economists have been closely monitoring any changes to the BOJ’s yield curve control policy, as it is a crucial part of the central bank’s plan to revive Japan’s economy and achieve its 2% inflation target after years of deflation. In response to the spike in commodity prices last year, the BOJ had to defend its yield limit by increasing bond purchases, leading to accusations of market price distortions and yen depreciation, which further inflated the cost of raw material imports. The changes announced by the BOJ aim to address these concerns.
In its quarterly outlook, the BOJ expressed optimism about the Japanese economy, projecting growth above its potential. The bank highlighted the emerging virtuous cycle driven by higher income, improved consumer sentiment, and increased spending. The central bank also noted signs of change in firms’ wage and price-setting behavior. The BOJ expects wages to increase further as Japan’s output gap turns positive around mid-fiscal 2023, which would enhance consumers’ purchasing power.
However, the BOJ has acknowledged that inflation will slow down by the end of this year. It downgraded its inflation median forecast for 2024 to 1.9% from the previous 2% and maintained its forecast of 1.6% for 2025. Marcel Thieliant, the Head of Asia-Pacific at Capital Economics, anticipates a potential slowdown in inflation due to lower import prices impacting goods inflation. He also suggests that if the economy enters a recession in the second half of this year as predicted, the case for policy tightening would diminish.
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