Reaching for zero: the upshot of the Bank of Japan's new announcement
The Bank of Japan (BoJ) recently announced shifts in its monetary policy, signaling a renewed commitment to spurring growth and boosting inflation.
The BoJ is now going to target 10-year Japanese government bond (JGB) yields, aiming to keep them at 0%. Moreover, the BoJ indicated its intent to overshoot the previously announced 2% inflation target, an attempt to compensate for having undershot it for so long.1 The goal is that these measures will boost consumer and investor confidence and push inflation expectations up. However, the success of these new policies will depend on key factors, including those related to perception and to execution. In our view, there are a couple of plausible scenarios for how the new policy might play out, and each one has different implications.
Scenario 1: the BoJ announcement fails to boost inflation expectations
The first scenario assumes that markets find the new yield target credible. Rather than the BoJ having to actually transact in 10-year JGBs to hit the zero yield mark, in this scenario market participants do the central bank's work for it, essentially deciding that it doesn't pay to fight the BoJ. This could prolong the potential lifespan of the asset purchase program already in place. On another note, negative interest rates have eaten into Japanese bank profits. If the BoJ maintains control of the short end of the yield curve with policy rates-and assumes control of the long end through the 10-year yield target-the BoJ could steepen the shape of the yield curve, thereby benefiting the banks, which tend to profit more as spreads between long and short yields increase. While this first scenario does indeed allay some investor concerns, it's difficult to see how it might translate into greater inflation expectations. By boosting 10-year yields to 0%, perhaps the private sector will feel more confident that individuals and corporations won't have to pay for negative interest rates and will therefore be more willing to spend and invest. However, this argument is a bit of a stretch in our view.
Scenario 2: inflation expectations rise and the government initiates fiscal stimulus
The second scenario involves the BoJ hitting its 10-year JGB yield target by backing off of its JGB purchases significantly, thereby reducing demand in the market, pushing the prices of the bonds down and yields up. Instead of buying long-dated JGBs, the BoJ could buy bonds at the shorter end of the yield curve, real estate investment trusts, equities, or other types of assets-but some of these prospective assets for the bank's balance sheets don't trade in markets deep enough to make a material difference.
If the BoJ stops buying up a large asset class-JGBs, in this case-and cannot effectively shift the immense volume of its purchasing power to other types of assets, then the central bank would essentially be reducing monetary stimulus, thereby offloading the onus of economic growth stimulation onto the Japanese government itself. In our view, this would not necessarily be a bad thing-it would force the government to make a decision. On the one hand, the government could continue to stall on structural reforms and engage in small-scale fiscal stimulus, pushing the economy further into the debt and deflation spiral that has caused two lost decades in Japan. On the other hand, the government could seize the initiative from the BoJ and engage in structural reforms or a massive fiscal stimulus or both. To finance a huge fiscal stimulus, the government would likely issue new JGBs, an incremental supply the BoJ could then return to the market and buy in order to keep 10-year yields level, at 0%. This type of fiscal stimulus, effectively financed by the central bank, is also known as helicopter money.
Helicopter money measures would require careful construction
It is too early to guess how the BoJ's latest monetary policy experiment will unfold. A move to yield targeting may well fail to translate into higher inflation expectations, but it could help Japan achieve what the U.S. Federal Reserve and the European Central Bank have tried to achieve for their economies by pushing politicians to engage in significant fiscal stimulus. In Japan, such a fiscal stimulus would likely be financed by the central bank, making it, in essence, helicopter money by stealth. If helicopter money is to succeed in stimulating demand in the Japanese economy, it must be carefully constructed. Japanese households tend to save, and having consumers receive a stimulus that goes straight to the bank defeats the entire purpose of helicopter money. Constructing this policy to ensure that the proceeds flow into the real economy, with the accompanying multiplier effect, is likely to be the next major experiment in Japan. In an era already marked by bold moves from the world's central banks, it seems that only the imagination can limit what policy innovations might await us next.
1 Bank of Japan, as of 9/21/16.