July’s monetary policy meeting could well be remembered as the moment the Bank of Japan (BOJ) began phasing out its seven-year-old yield curve control (YCC) program, or at least took a major step toward an eventual exit. In our view, the changes in YCC could help the program phase out gradually as the conditions that prompted its creation (persistent low inflation and low growth) also diminish, without prompting a disruptive rise in yields. We also do not expect a significant adverse impact on global financial markets from the YCC changes.
The BOJ said it is making YCC more flexible while maintaining the 0% target yield level for 10-year Japanese government bonds (JGBs). One major policy change is that the plus and minus 0.5 percentage points around zero will no longer be “rigid limits” but instead “references” in the bank’s market operations. The bank also raised the target level at which it would conduct a fixed-rate JGB purchase operation every business day, from 0.5% to 1.0% on 10-year JGBs.
By way of background, the BOJ’s YCC was introduced in September 2016, eight months after the bank surprised markets by lowering its short-term policy rate to −0.1%. Then, in July 2018, the bank defined plus and minus 0.2% as limits for 10-year JGB yields. Further tweaks to the yield target band were made to pursue flexibility and sustainability of YCC: plus, and minus 0.25% in March 2021 and plus and minus 0.5% in December 2022.
A phaseout of YCC would help mitigate its inherent problems
YCC has posed both benefits and drawbacks. The BOJ’s unique policy tool has been powerful in helping suppress long-term real market rates well below real neutral rates, contributing to the depreciation of the Japanese yen, helping ease financial conditions broadly, and hence stimulating overall economic demand.
However, one issue with YCC’s design is that it could become too stimulative once the BOJ’s 2% inflation target actually comes into sight: Real rates would tend to shift even lower with 10-year nominal yields capped and inflation expectations rising, suggesting the policy should indeed be adjusted so it is less stimulative, not more. This “procyclicality” is an inherent problem with YCC, and July’s BOJ statement suggests that mitigating this problem is the bank’s main motivation for its decision:
“Japan’s recent inflation rates … are higher than projected in the April 2023 Outlook Report, and wage growth has risen …. If upward movements in prices continue, the effects of monetary easing will strengthen through a decline in real interest rates ….”
As time passes and circumstances change, policies that once appeared appropriate often must adapt. What economists call “time inconsistency” can be disruptive for the markets and economy, and potentially damage a central bank’s credibility. BOJ Governor Kazuo Ueda had mentioned this in relation to YCC prior to becoming the central bank chief in April, and at the press conference following July’s meeting, he again raised potential issues around the procyclicality of YCC.
The BOJ’s risk assessment and narratives on its inflation outlook support the changes made to the YCC program. In the July 2023 Outlook Report, though the bank’s forecast for consumer price index (CPI) inflation excluding fresh food was slightly lowered to 1.9% year-over-year for fiscal 2024 and kept unchanged at 1.6% for fiscal 2025, the bank notes upside risk for 2024 inflation and removed a downside risk narrative from its 2025 forecast.
An elegantly designed phaseout
Keeping the 0% target for 10-year JGBs with plus and minus 0.5% references (no longer rigid limits) and the new 1% upper limit is an elegantly designed phaseout for the YCC, in our view.
The limited history of central banks exiting rate cap policies suggests this move can be disruptive. Governor Ueda noted the examples of the U.S. Federal Reserve (Fed) in 1951 and the Reserve Bank of Australia (RBA) in 2021.
The seemingly complicated new design for the BOJ’s YCC could be much less disruptive; we believe the BOJ may have addressed the procyclicality challenge before it becomes unmanageable. The BOJ would allow (or even welcome) 10-year JGB yields to rise above 0.5%, as long as the nominal yield rise is due to higher inflation expectations consistent with the 2% inflation target and/or a healthy rise in real rates that reflects stronger economic growth. Under those conditions, the YCC program could automatically be phased out with little disruption to the markets and real economy. Or, in an adverse economic scenario where inflation rates decline and do not rise again to the 2% target, the YCC program could simply continue and suppress yields lower as needed.
In essence, with July’s announcement, we believe the BOJ has likely succeeded in limiting the risk of its policy being procyclical and disruptive in a successful inflation scenario while retaining the powerful easing tool with the same yield target for an unwelcome back-to-deflation scenario.
Short-term policy rate unchanged
The BOJ kept its short-term policy rate unchanged at −0.1%. The bank likely needs more data to become confident that its 2% inflation target has been met in a sustainable and stable manner (a condition for its forward guidance) before considering a change. However, the market may start testing the BOJ on the short-term policy rate before too long. Inflation dynamics seem to be changing, even in Japan.
Bottom line
July’s BOJ decisions could likely turn out to be a phaseout of YCC. The bank would allow JGB yields to rise, if gradual and consistent with growth and inflation, with the new cap at 1.0%.
One concern is whether JGB yields could reach 1% too soon, with momentum to rise further. We believe JGB yields will likely stay contained: If yields were to rise anywhere close to 1%, we would expect strong domestic demand for Japan duration would be enough to hold yields at that level for now – at least until the BOJ’s 2% inflation target is finally met.
We also do not expect a significant adverse spillover to global financial markets from the BOJ’s YCC changes. Many Japanese investors have already offloaded a large quantity of foreign bonds as their currency hedging costs rose with the U.S. Fed and other central banks hiking their policy rates. This should help limit additional appetite for domestic investors to sell foreign bonds to buy Japanese bonds.
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