Bank of Japan at the Policy Frontier

Since Governor Haruhiko Kuroda took office in March 2013, the Bank of Japan (BoJ) has been the most aggressively expansionary advanced-economy central bank. Its announcement last month of a “new framework for strengthening monetary easing”—coming only six months after introducing negative policy rates—distances it even further from the pack.

That a central bank is willing to assess its performance transparently and to consider new approaches to achieving its key goals is something we have come to expect. While it’s much too early to tell whether the latest BoJ innovations will be more successful, there is reason to be skeptical. No less important, the new approach involves risks to the central bank and to financial market stability that may not be fully appreciated. Given the difficulties that other advanced-economy central banks seem to be having in raising inflation and inflation expectations, how the BoJ fares is of interest far beyond Japan.

The BoJ’s policy challenge stands out because, after a generation of falling prices, deflationary expectations were deeply embedded when Mr. Kuroda became Governor three and one-half years ago. Moreover, businesses and households correctly anticipated that the need to control the country’s rapidly rising sovereign debt would lead to many years of fiscal restraint.

Confronted with this very challenging environment, in March 2013, the BoJ implemented one of the largest central bank policy shifts in modern times, raising the central bank’s inflation target explicitly to 2 percent and kicking off the most rapid expansion of its balance sheet among the leading central banks. It was and remains a radical experiment in expectations management. Since the policy change, the BoJ’s holdings of Japanese Government bonds (JGBs)—its largest asset—have jumped by factor of nearly four, rising from 11% to 37% of total JGBs outstanding. And, the central bank currently still aims to increase its holdings by about ¥80 trillion annually—about 16 percent of nominal GDP and far in excess of annual JGB issuance.  (This means that, by late next year, BoJ assets will reach 100 percent of Japanese GDP, compared to perhaps 35 percent for the ECB and less than 25 percent for the Federal Reserve.)

Deflation did turn to inflation, at least for a while. But as of August 2016, core CPI inflation (measured by the trimmed mean CPI) was back at 0.0%, barely above the -0.3% recorded before Governor Kuroda took office. Not only that, but after having initially risen following the April 2013 original implementation of “Quantitative and Qualitative Monetary Easing” (QQE), measures of medium- and long-term inflation expectations have receded, in some cases sharply. For example, after peaking at nearly 1.4 percent in mid-2015, the five-year-forward five-year inflation swap rate is now close to zero, little changed from before the December 2012 Diet election that made Shinzo Abe the Prime Minister (see chart). Perhaps most disheartening is the plunge in early 2016: over the month following the BoJ’s announcement of its negative interest rate policy on 29 January, the Japanese inflation swap rate declined from nearly 0.5 percent to zero.

Five-year-ahead, five-year Japan inflation swap rate, 2012-27 October 2016

Note: Vertical red line denotes December 2012 Diet election. Vertical blue line denotes day before announcement of negative interest rate policy. Source: Bloomberg.

Against this background, the BoJ undertook a “comprehensive assessment” of economic conditions and the impact of monetary policy, issuing its conclusions last month. The new framework—dubbed “Quantitative and Qualitative Monetary Easing with Yield Curve Control”—includes two key policy shifts: (1) the introduction of a target level for the 10-year JGB yield of around zero percent; and (2) a commitment to continue expanding its balance sheet until inflation (measured by the CPI less fresh food) exceeds 2 percent and “stays above the target in a stable manner.”

What should we make of this? What do these new commitments mean? Will they be effective in raising inflation expectations and inflation?

Let’s start with the second part—the overshooting commitment. One of the BoJ’s challenges is to overcome the damage the decades-long deflation has done to its credibility. The promise to overshoot the 2-percent inflation target is a form of state-contingent forward guidance designed to bolster the perception of the central bank’s policy commitment in the minds of those setting wages and prices. The commitment comes with a clarification of the BoJ’s definition of price stability: namely, “attaining a situation where the inflation rate is 2 percent on average over the business cycle” [our emphasis].

This version of inflation targeting shares key features of a price-level or nominal GDP target. Advocates of the latter frameworks (see, for example, Woodford) view them in part as devices that can lower the expected real interest rate at the effective lower interest rate bound (ELB). With a price-level target, for example, sub-target inflation is expected to be followed by above-target inflation. That is, policymakers are committed to make up for lost ground rather than (as in the case with many forms of inflation targeting) ignore past misses. So, imagine a situation in which a central bank has a 2 percent inflation target, but actual inflation has been 0 percent for two years and the interest rate is at the ELB (modestly below 0 percent). With an inflation target, the real interest rate cannot go much below -2 percent. But instead, if the central bank has a credible price level target, people will expect inflation to rise temporarily to 4 percent, so the real interest rate can fall to -4 percent.

So, it is possible that the new strategy could lead inflation expectations to rise above 2 percent, reversing the deflationary Japanese mindset once and for all. A massive regime shift can suddenly halt and reverse deflationary expectations, as we saw when the United States exited the Gold Standard in 1933 (see our recent post).

Unfortunately, experience is not on the BoJ’s side. Absent other economic and policy changes, it is unclear why continuous expansion of the central bank balance sheet alone will have a significantly greater impact either on expectations or on the plans of wage- and price-setters going forward than it has had in the past. The best hope is that a tighter labor market—arguably the tightest in 25 years—eventually will lead to faster wage gains. At the same time, with Governor Kuroda’s current term due to expire in March 2018, forward-looking observers may question how binding this overshooting commitment will be on a future BoJ Policy Board.

How about “yield-curve control” and the new 10-year JGB yield objective? Economists have long viewed the introduction of a target for a government bond yield (rather than an overnight rate) as one of the most unconventional of unconventional monetary policy tools. Then-FRB-Governor Ben Bernanke expressed a preference for this approach in his famous 2002 talk about tools to prevent or address deflation. A decade later, Larry Ball asked why the Chairman Bernanke chose not to use this tool.  

When targeting a bond (of anything but an extremely short maturity), a central bank can determine either the price or the quantity, but not both. One reason for the Fed’s focus on quantity rather than price is that targeting a long-term government bond yield raises risks of balance sheet instability, something highlighted in a recently-released 2010 FRB staff memo.  To understand why, it is important to realize that targeting the yield means offering to buy and sell the long bond in unlimited quantities. As the Fed memo notes, if investors suspect that the central bank is going to raise its yield target, thereby driving down the price of the bond, there will be a rush to sell and a massive expansion of the central bank balance sheet. The converse also applies: a belief that policymakers might lower the yield target can prompt a disruptive scramble to purchase the debt.

With regard to the loss of balance sheet control, a useful recent analogy is the Swiss National Bank’s effort from September 2011 to January 2015 to cap the Swiss franc versus the euro (see our earlier post). The SNB committed itself to acquire euros without limit, making the size of its balance sheet endogenous. However, doubts about the commitment, reflecting financial disruptions in the euro area, the advent of quantitative easing by the ECB, and Swiss political concerns about the potential losses on SNB holdings of euros, meant that the SNB had to acquire a massive volume of euros—as much as 70 percent of GDP—to maintain its commitment. As a result, when it reneged on the commitment in 2015, the SNB experienced large capital losses.

No less important, by making its balance sheet endogenous, a central bank that targets a government bond yield passes monetary control to the fiscal authorities, who decide how much of the yield-targeted instrument to issue. Fiscal expansion financed by central bank money is what is widely called helicopter money (see our earlier post), and can be quite powerful. But the transfer of monetary control can lead to fiscal dominance that is politically difficult to reverse.

The most well-known central bank experience with targeting longer-maturity government debt was the Fed’s commitment to cap the U.S. Treasury yield curve beginning in 1942. The yield curve pledge facilitated wartime finance: from 1942 to 1949 monthly estimates of the constant-maturity 20-year yield had a standard deviation of only 8 basis points. Following World War II, however, inflation reached double-digit levels during 1947 and 1948. It wasn’t until the Treasury Accord of 1951—amid inflationary pressures from the Korean War—that the Fed was able to exit this commitment, and only after open confrontation between the Fed and the Treasury (see Hetzel and Leach).

Following the BoJ’s September 21 announcement, there was some uncertainty about whether it would make its balance sheet fully responsive to changes in government bond issuance and private demand for 10-year JGBs, partly because of its unchanged plans to acquire JGBs at an ¥80 trillion annual rate. It appears, however, that the BoJ simply expected that the existing acquisition pace would be consistent with the new yield pledge. In effect, the BoJ was revealing its estimate of the private demand curve for JGBs.

In a recent Brookings talk and discussion, Governor Kuroda made clear that the commitment to yield curve control means that the BoJ’s balance sheet will be endogenous. He also argued that the BoJ retained independent monetary control because it can revise the yield target at any time. We are skeptical, as targeting flexibility could easily aggravate market instability. As we already noted, any suspicion that the central bank will alter its target could trigger massive private sales or purchases, with the central bank compelled to take the other side of the transaction until the Policy Board acts.

There also is another, more persistent, source of doubt about the BoJ’s willingness to use all its monetary policy tools to the fullest: namely, the well-being of Japan’s financial intermediaries. For example, the BoJ’s comprehensive assessment highlighted risks to intermediation from the flattening of the yield curve following its March shift to a -0.1 percent policy rate. The September choice not to lower its policy rate further—say, closer to the -0.4 percent level set by the ECB—suggests that the BoJ would be uncomfortable with a further yield curve flattening, as well as with any policy that might constrain intermediaries.

So, has the BoJ’s policy worked? The charts below suggest that the revised policy framework has been mildly stimulative for financial conditions over the past month. As intended, the 10-year JGB yield has barely budged, while the yen has weakened modestly and the equity market has risen somewhat. That said, the yen is still 14 percent stronger versus the dollar than it was on average in 2015, while the stock market is down by 12 percent.

Japan: 10-year JGB yield (basis points) and the Yen-U.S. dollar exchange rate, September 1-October 24, 2016

Note: The vertical blue line denotes September 20, the day before the BoJ policy announcement. Source: Bloomberg.

Japan: 10-year JGB yield (basis points) and the TOPIX Index, September 1-October 24, 2016

Note: The vertical blue line denotes September 20, the day before the BoJ policy announcement. Source: Bloomberg.

Our bottom line is that, by making their balance sheet endogenous, the new BoJ policy framework of yield curve control is potentially more aggressive than previous incarnations of QQE, either the original or the one with negative rates. However, unless policy has a significantly larger impact on financial conditions going forward than it has thus far, the revised framework is likely to remain insufficient to achieve the central bank’s inflation target any time soon.

What’s left in the monetary policy toolbox that has not been tried? Not much. The BoJ has ballooned its balance sheet from roughly one-third to nearly 90 percent of GDP while broadening the scope of its purchases to include private bonds and equity and lowering the policy rate below zero. Now, it has shifted toward a framework akin to price-level targeting and targeted a zero yield on the 10-year JGB. We see only one significant tool remaining: an explicit exchange rate target aimed at keeping the yen at least slightly undervalued; what Lars Svensson described in 2001 as the “foolproof way” to raise inflation. But, in the case of a large, mature economy like Japan, explicitly promoting yen depreciation would be viewed as extremely unfriendly and could easily trigger protectionist retaliation.

Acknowledgement: We are grateful to friend and former colleague, Jeffrey Young, for his very helpful suggestions.