By Tiffany Wilding, PIMCO North American Economist, and Tomoya Masanao, Head of PIMCO Japan and Co-head, Asia-Pacific Portfolio Management Last week the Bank of Japan surprised many by doing, well, nothing. Media reports and market developments since the BOJ’s surprise decision at its previous meeting in December to widen the target band for 10-year Japanese government bond (JGB) yields suggested that tweaking or altogether scrapping the Yield Curve Control (YCC) framework after seven years of implementation was possible or even likely at the January meeting.
As a result, intensive selling pressure ahead of the meeting drove the yield on the 10-year JGB to a high of 53 basis points (bps) – slightly above the BOJ’s (widened) target range of −50 bps to +50 bps. Yet, not only did the Bank of Japan continue with YCC last week, it appeared to reinforce it by extending the maturity on its term lending facility operations (“funds supplying operations” in BOJ parlance). And, indeed, the BOJ’s moves had the intended effect: The selling pressure quickly subsided and the 10-year JGB yield rallied around 10 bps, to 40 bps – where (as of this writing) it is still trading. At the same time, yen-denominated interest rate swap spreads, which had been steadily widening relative to JGBs since the beginning of 2022, narrowed around 15 bps to a spread of just above 30 bps. Still, we see several reasons why the BOJ’s surprising moves – widening the 10-year YCC band, which previously BOJ Governor Haruhiko Kuroda had argued should be viewed as a policy tightening, while reinforcing the anchor on 10-year rates through enhanced term lending operations – suggest policymakers may be laying the groundwork to further ease YCC while taking steps to minimize the potential volatility in Japanese and global bond markets. First, and arguably most important, although the BOJ’s January forecasts for inflation remained relatively muted, Japanese inflation has accelerated. Higher global energy prices and the sizeable yen depreciation in 2022 have pushed measures of the Japanese inflation rate higher. PIMCO’s “sticky price” measure for Japanese inflation has accelerated to just under 3% annualized for the first time in decades, while anecdotes ahead of annual “shunto” wage negotiations suggest that workers at large firms may be getting more substantial wage hikes. A major Japanese fast fashion retailer made headlines after announcing a 20% wage hike, while according to media reports the Japanese Trade Union Confederation is seeking a 3% increase in pay. While it is yet to be seen whether broader wage rates, which include the small and mid-sized firms that make up the majority of Japanese employment, will reach the BOJ’s soft goal of 3%, there is reason to be optimistic. Second, the politics of YCC have become increasingly challenging, with Prime Minister Fumio Kishida distancing himself from Abenomics. When YCC was first implemented in 2016, many read it as an open invitation from Kuroda to Japanese government officials to issue as many JGBs as they wanted to engage in more expansionary fiscal policy. The hope was that this would eventually lead to sustainably higher domestic loan growth and inflation, which would offset some of the costs of the BOJ’s easing programs – including to the banking sector, which has had to live with a negative BOJ deposit rate and relatively flat interest rate curve. Although the government has implemented expansionary fiscal measures similar to other countries and instituted various pandemic supports, the continued focus on VAT hikes and other fiscally contractionary measures suggest the government never fully took up the BOJ on its invitation. Furthermore, concerns about the adverse consequences of quantitative easing (QE) and low rates on income and wealth bifurcation have steadily gained political focus. More recently, amid the rise in global interest rates, many observers blamed YCC for last year’s sharp depreciation in the yen. Third, Kuroda will step down as BOJ governor in April, and media reports suggest his successor may be more aligned with Kishida’s political agenda. Hirohide Yamaguchi has recently emerged as a candidate; he was a deputy governor of the BOJ under former Governor Masaaki Shirakawa, and had suggested in a 2022 interview a more flexible policy framework and YCC target band widening before the BOJ’s December announcement. Despite the various motivations for easing YCC, the BOJ still has the tall task of doing so in a way that is orderly and doesn’t require unsustainably large purchases of JGBs. On this, the BOJ’s announcement to enhance its term lending facility was a potentially elegant solution. While the lending facility was introduced along with the YCC framework in 2016, by tweaking it last week the BOJ sent a strong signal that it could be more aggressively used to provide banks with a powerful incentive to buy JGBs at whatever levels the BOJ prefers. For example, if the BOJ hypothetically sets the rate at which banks can borrow at 0% for up to 10 years, banks would likely want to buy JGBs at some spread over zero to compensate them for the additional regulatory capital charges incurred for doing this trade (maybe these charges are already reflected in the 40 bps current yield of the 10-year JGB). This could in principle serve as an anchor, allowing the BOJ the flexibility to ease YCC while getting buying support from banks. To be sure, moving away from YCC while limiting market volatility would be arguably unprecedented. History suggests that markets aren’t kind to policymakers who want to exit rate or currency pegs.Nevertheless, the BOJ may see success in reestablishing its credibility to defend the YCC if the term lending facility is successful. For the next governor, we suspect the benefits of maintaining that credibility through easing out of the policy outweigh any incentive to abruptly abandoning it.
