Bank of Japan will fill the QE gap, as Fed and ECB back off
- BoJ governor Haruhiko Kuroda kept a low profile at the Jackson Hole summit
- BoJ will continue quantitative easing until its inflation goal has been “observed”
- There is a potential conflict between QE and yield curve control strategies
- The central bank may have the QE space to itself next year
The Federal Reserve and European Central Bank are likely to begin winding back the size of their balance sheets by the end of the year. The Bank of England would follow suit in due course. The Swiss National Bank, the most aggressive of the lot, is already easing up as EURCHF rallies. But the Bank of Japan looks set to fill any gaps in global QE, keeping its foot on the accelerator until 2019/2020.
No one knows the extent to which balance sheet size in isolation has been a determining factor in FX rates, but with the other players leaving the field, it seems as if the path of least resistance for JPY will be down across the board, a trend punctuated by occasional risk-on corrective rallies.
Bank of Japan Governor Haruhiko Kuroda kept a low profile at the Jackson Hole symposium, participating in a labour market panel discussion and giving an interview to Bloomberg, but he didn’t deliver a formal address. Apart from a couple of scheduled speeches from policy board members, we will not hear much from the bank until its next policy review meeting on September 21.
That’s because there is not much to talk about. Last Friday’s inflation update showed headline inflation in Japan crawling up to an annual rate of 0.50% but the core rate is barely positive at 0.1%. ”The economic and price situation in the US is much, much better than in Japan,” Kuroda told Bloomberg, and an accommodative monetary policy would be in place “for some time” because the “deflationary mindset” has yet to be overcome.
Japan's inflation chart
Source: Japan Macro Advisors
Like everyone else, the BOJ governor was surprised a couple of weeks ago when the second quarter GDP number for Japan came in at a 4% annualised rate, way above the economy’s medium term potential, estimated to be below 1% (largely due to adverse demographics).
In theory, above potential growth should be inflationary, especially when the unemployment rate is already under 3%. But markets didn’t react much to the GDP number, firstly because the initial reading is subject to substantial revisions, and secondly because there is little evidence an improving economic situation is having any effect on inflation.
Japan's GDP graph
Source: Financial Times
The Bank of Japan expects inflation to reach its 2% target in the 2019/2020 fiscal year. They intend to continue expanding the monetary base (quantitative easing) and practising yield curve control until the target has been “observed”, not just forecasted. That’s in contrast to most other central banks who conduct monetary policy on a forward looking basis, withdrawing stimulus in anticipation of inflation targets being met.
But there is a potential conflict between the QE and yield curve control strategies, evidence of which has shown up in recent weeks. QE will be implemented via monthly purchases of government bonds, aiming to increase the bank’s total holding by about ¥80 trillion per year. Meanwhile yield curve control will be maintained by holding the deposit rate at –0.10% and the yield on the 10-year JGB at + 0.10%.
Trouble is, that’s trying to keep two balls in the air at the same time – controlling both the quantity of purchases and the price of those purchases, something we learn in ECON 101 is not possible. One needs to be prioritised over the other. And it seems the BOJ has decided to prioritise the bond yield. In line with global moves, the yield on the 10-year JGB has declined in recent weeks (see chart below; please click to enlarge). It is now approaching the bank’s “around zero percent” target. To prevent the yield from dropping under the target, JGB purchases have been reduced, in turn slowing the rate of QE.
Furthermore, explains Kuroda, “Since JGBs remaining in the market is going to decline, that means that with one unit of JGB purchase, the impact on the interest rate could be bigger, so that in coming months there will be less and less need to purchase JGBs in order to maintain the yield curve.
Some read this as an ploy to pull the wool over the eyes of the markets and conduct QE tapering by stealth.
Japanese government bonds chart
Source: Bank of Japan, Metastock
But what if the BOJ sticks with its planned QE expansion until 2% inflation is achieved sometime in 2019/2020 ?
At the moment, the balance sheets of the Federal Reserve, European Central Bank and Bank of Japan are each worth around $4.5 trillion, as shown in the chart below. But it looks like the Fed will shortly begin reducing its exposure and many expect the ECB to follow suit. That would leave the BOJ forging ahead on its own into uncharted territory, accumulating a balance sheet equal in value to Japan’s GDP.
Japan's quantitative easing chart
The Bank of Japan may have the QE space to itself next year, as the Fed and ECB wind back on unconventional monetary policy. But at some stage a decision will have to made to prioritise QE over yield curve control or vice versa. That decision could be taken out of their hands depending on movements in global bond markets.
Not even the BOJ will be able to stand in front of a moving train if yields break to the upside in the US. How the BOJ manages the trade-off between QE and yield curve control when it is put to the test will have a major impact on JPY.
– Edited by Robert Ryan
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Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.