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 ….”