By Karsten Junius, chief economist at J. Safra Sarasin Sustainable Asset Management
We expect the BoJ to turn less dovish when it meets on October 31. Higher inflation forecasts from board members as well as yen weakness should be sufficient reasons for the BoJ to take another step along its long path towards policy normalisation.
A further adjustment in the conduct of its YCC policy, letting market forces play a greater role in shaping the yield curve, is likely.
We expect the Bank of Japan (BoJ) to turn less dovish when it meets next week. New forecasts showing higher inflation rates for fiscal year 2023 and 2024, as well as the weaker yen, should be a catalyst for the BoJ to change its Yield Curve Control (YCC) policy once again. At a minimum, we expect its forward guidance to be more balanced.
Since the BoJ published the July forecasts of its Policy Board Members, inflation has continued to run above expectations. The yen has lost almost 5% against the dollar, while the oil price has risen by 9%. As a result, imported inflation and its impact on consumer prices will be higher than the BoJ previously anticipated. In the near-term, therefore, annual inflation rates are likely to fall more slowly than previously anticipated.
This should also impact the BoJ’s medium-term outlook for inflation. The outlook is essentially anchored around two components: (i) inflation expectations and (ii) the output gap. Both should impact wage growth and firms’ wage- and price-setting behaviour. Importantly, inflation expectations in Japan appear to be largely adaptive, i.e., heavily influenced by past inflation. Surveys that the BoJ tracks closely have indeed shown that medium-term expectations of both households and firms point to persistently more elevated inflation.
In addition, the BoJ’s output gap estimate – which captures the utilisation of labour and capital – has closed in Q2, and high-frequency indicators suggest that it turned positive in Q3. While this is in line with its previous forecast, a more sustained pace of GDP growth in the second half of the year and into next year, reflecting a stabilisation of growth in China, a resilient US economy and likely more fiscal support to offset elevated energy prices, point to a more rapid rise in the output gap than the BoJ indicated in July. This would also imply stronger medium-term inflationary pressures.
We believe the BoJ is likely to revise up its CPI inflation (all items less fresh food) forecasts to around 3% for FY23 (from +2.5% in July) and to 2.0-2.3% for FY24 (from +1.9%). This would point to CPI inflation exceeding the 2% target for three years from FY22 and fulfilling the BoJ’s “inflation-overshooting commitment”, which is one pillar of its quantitative and qualitative monetary easing (QQE) with a negative interest rate policy.
Another factor that is likely to influence the BoJ’s decision is the renewed downward pressure on the yen. Over the past few weeks, the government appears to have had to step up its yen purchases to slow down the depreciation. While we don’t expect the BoJ to change its stance just to contain the depreciation – the weakness of the yen helped the BoJ over the past year to boost inflation and inflation expectations – there is a case to be made that at this point, a further easing of financial conditions is not warranted given the more endogenous drivers of inflation that are in place. Modifying or even scrapping YCC might provide only a limited and short-lived boost to the yen given the strength of the US economy and expectations for US interest rates to remain elevated. But failing to move towards a more normal policy stance would add to existing downward pressure on the yen, which the authorities might find difficult to contain.
Scrapping YCC altogether could be too radical for the BoJ at this stage, though not impossible. Still, it has different options to further loosen its control on the curve, such as (i) shifting the formal upper limit on the 10-year JGB yields from 0.5% to 0.75%, while keeping the ‘strict cap’ at 1%; (ii) raising the ‘strict cap’ above 1%, (iii) targeting the 5-year instead of the 10-year, allowing a great portion of the curve to be market driven.
To sum up, we think there is a strong case to be made for the BoJ to gradually shift its policy towards a somewhat less accommodative stance. Large upward revisions to its July inflation forecasts for both this fiscal year and next, as well as renewed downward pressure on the yen, should be sufficient reasons for the BoJ to turn less dovish. Another adjustment to its YCC policy is therefore highly likely. We do not rule out either the possibility for the BoJ to scrap it altogether, while controlling the long-end of the yield curve by committing to keep the negative interest rate policy in place for an extended period of time – until at least spring next year when the next annual ‘shunto’ wage negotiations take place.
